Thursday, February 28, 2008 35 Comments

Return to Castle Goldenstein: the gold market in a nutshell

With the Fed sounding like they share an office with the Hillary campaign - any minute now, I fear, Dr. Bernanke is going to crack and accuse Greg Ip of fluffing the euro's pillow - and the metals markets bubbling over like a bad quesadilla, perhaps it's time for me to share some of my eccentric thoughts on the old yellow fellow.

Our goal today is to understand the gold market, from King Tut till now. We'll start with abstract economics, whip through some financial history, and wind up in the weird world of ETFs, DGCs, the CBGA, Comex and the IMF. If these letters mean nothing to you, all the better. Most of what most people know about gold is, in my humble opinion, wrong.

Of course, my opinions about gold are just that. I am neither an economist nor a financial professional. I am certainly not a registered investment advisor! Everything I know about precious metals, I taught myself. If any aspect of my presentation inspires any confidence or respect, I am probably doing something wrong.

At the very least, please do not make financial decisions with reference to my eccentric economic theories, which are probably also fascist, sexist and anti-Semitic, unless you are at least sure you understand them and could defend them in a fair argument with an intelligent and well-informed paperhead. I should also mention that my own derisory savings are all in cash, ie, gold and silver bullion - not, in case anyone plans a raid on Castle Moldenstein, retained therein. (Can you say "Zurich," boys and girls? I knew you could!)

First, the fundamental fact about gold is that it is a natural currency. James Turk (whose satisfied customer I am) is by no means infallible, but this brief post of his makes as good an introduction as any. This lovely freelance piece in the SF Chronicle, by local comedy man Rob Baedeker, is the first sympathetic treatment of a goldbug I have ever seen in any newspaper. When gold is hip, governments wake up in a stone-cold sweat.

However, the starting point for my amateur aurology is a mysterious essay that appeared in 2006 on the notorious doom-mongering financial aggregator Safehaven. Its author, the blatantly pseudonymous John Law, has not reappeared and does not appear to be answering his email. I think it's pretty safe to assume he was run over by a bus. While I certainly don't agree with all of Mr. Law's opinions (and it should be noted that the financial crisis he predicts, a currency run, is not at all the same thing as the financial crisis which is happening now, a bank run), I think his basic theory of money is more or less right. If gold is money, there's no way to explain gold without explaining money. So let me give it a whack.

To make a long story short, Law's theory of money is that currency selection is a coordination game, driven by appreciation effects rather than coincidence of wants. As we'll see, this is not quite the same as the Menger-Mises Austrian theory of money, but it could be seen as a variant - "neo-Austrian," perhaps. The classical Austrians had many advantages. Game theory was not among them. But if you think of Mises' "regression theorem" as a sort of proto-game theory avant la lettre, you may be on the right page.

Perhaps this is all gobbledegook to you. What is money? In our usual UR style, try and forget everything you know about the stuff. Imagine you are an incredibly advanced alien, and your spaceship has developed some kind of awful navigation defect that misrouted it to Planet Three. While you're waiting for the natives to advance their crude technology far enough to at least patch your quantum warp belt, you have nothing better to do than to study their barbaric economic habits, past and present.

You notice an weird pattern of trade that seems to hold across a variety of civilized societies. I'll let Carl Menger describe it, in his On the Origins of Money (1890):
There is a phenomenon which has from of old and in a peculiar degree attracted the attention of social philosophers and practical economists, the fact of certain commodities (these being in advanced civilizations coined pieces of gold and silver, together subsequently with documents representing those coins) becoming universally acceptable media of exchange. It is obvious even to the most ordinary intelligence, that a commodity should be given up by its owner in exchange for another more useful to him. But that every economic unit in a nation should be ready to exchange his goods for little metal disks apparently useless as such, or for documents representing the latter, is a procedure so opposed to the ordinary course of things, that we cannot well wonder if even a distinguished thinker like Savigny finds it downright 'mysterious.'
In other words, Menger - writing of course in the heyday of the classical gold standard - observes the following mystery: a strange good which appears to be of very little use at all, and yet is fervently desired by everyone.

First, note the contrast with modern goldbug twaddle of gold's "intrinsic value." While gold is certainly more useful than green slips of paper, the difference is minor in perspective. Pretty much anything you can get in exchange for a Krugerrand is much, much handier around the house than the Krugerrand. While it is not obvious that the same logic explains the anomalous valuation of Krugerrands and benjamins, Occam's razor suggests that we should at least give it a shot.

There is a second strange observation, which Menger doesn't make but I will. This is that, in addition to being anomalously overvalued, the good in question is anomalously stockpiled. For example, there are about 150,000 tons of gold in the world today, most of which is being used for nothing at all. Obviously the same observation holds for paper currencies.

This is a very different pattern than we see for other commodities in the Wall Street sense of the term - say, wheat, or zinc, or frozen concentrated orange juice. While there are warehouses full of all of the above, the stock-to-production ratio of gold is orders of magnitude higher than for any other good (even other precious metals). Since annual gold production is about 2500 tons, the gold industry keeps 60 years of inventory on hand. Imagine if this was the case for, say, iPods. Or even zinc. Its bizarre stock-to-flow ratio is the easiest way to see that, even in the futuristic techno-world of 2008, gold remains a monetary commodity.

(It is very difficult to distinguish "monetary" from "industrial" users of gold, largely because a large percentage of today's gold stockpile is held in South Asia as investment jewelry. The linked Daniel Gross essay, sourced from the egregious Virtual Metals, is a classic example of how analyzing a monetary good using ordinary commodity-market tools produces gross systematic errors. Except for psychological reasons, it matters very little how much gold is extracted every year. The number could go up to 5000 tons or down to 0. Either is a small addition to the stockpile. There is no reason to assume that these small annual deltas have any large direct effect on the gold-dollar exchange rate. Gold is gold, new or old.)

So, putting our alien hat back on, we have a rough general picture of this strange phenomenon, "money." It is a good that is either not very useful or downright useless, but still is considered very desirable, and is stockpiled in large quantities.

Why would this be? Is it some quirk of hominid psychology, an irrational, instinctive attraction which leads the violent hairy biped to crave shiny metals and pictures of dead presidents? Is this why every advanced society seems to have at least one such good?

We certainly can't rule it out. However, a simpler answer presents itself.

Suppose our hominids are engaging in the following pattern of trade, which we'll call the monetary transaction pattern. At time T0, our hominid produces some original good or service, O, and exchanges it for some intermediate good, I. He holds I until time T1, when he exchanges it for some final good or service, F, which he consumes.

Between T0 and T1, the subject thus holds a stockpile of I, a good which he has no plan to use. Does this ring a bell? Perhaps the phenomenon we call "money" is the result of a whole society of hominids who, for whatever bizarre bipedal reason, have all chosen the same I.

This explains the anomalous stockpile. It does not explain the anomalous valuation. And it tells us nothing about why hominids might engage in this odd behavior. Why, for example, doesn't our hominid just keep O until T1, and exchange it directly for F?

Here's a simple example of the MTP. Our subject, Sven, is a fisherman. His original good, O, is fish. Salmon, perhaps. His final good is a white Cadillac convertible, with wire wheels. His plan is to net salmon for 20 or 30 years, then buy the Caddy.

If Sven just keeps O until T1, he will have a huge pile of rotten salmon in his backyard. Frankly, this is no way to retire. Hope is not a retirement strategy, especially when all your assets are in fish. At least it's liquid - sort of. But it won't get you any Cadillacs.

So Sven exchanges O for a storable good, I, such as palladium, and he is happy. In other words, the MTP exists because the Svens of the world want to exchange present goods for future goods, O at T0 for F at T1, fish now for Cadillacs later, and because not all O are storable. Therefore, Sven has to select some good which is easy to store, I - palladium.

One way to understand the MTP is to create a strange world in which it does not exist. Imagine if we modify Nitropia so that anyone can trade with anyone, anywhere, by teleporting goods. In addition, we'll assume that all goods can be stored perfectly without any overhead. Is the result a premonetary equilibrium, in which no one has any reason to stockpile an item he has no plans to use? I believe it is, but it is also about as unrealistic as it gets. With all the monsters in the world, a Nitropia with these rules would be pretty boring.

We can break this premonetary equilibrium in a number of ways. And herein lies the rub.

Menger's classical Austrian theory of the origin of money relies on the coincidence of wants. (The same is true for the latest neoclassical theory, that of Kiyotaki and Wright, which may interest you if you're behind the firewall and have some kind of pathological, Aspergery obsession with mathematical pseudocode. Otherwise, stick with Menger, or his successor Mises, or later Rothbard. The classical Austrians may not have been right about everything, but at least they knew how to explain economics in English. Or German, anyway.)

In Menger's world, Sven selects palladium for a very simple reason. He has salmon and nothing else. At T0, he trades with someone who has palladium, and wants salmon. At T1, he trades with someone who has a Cadillac, and wants palladium.

Why palladium? Why do we use TCP/IP, rather than DecNET or Appletalk? Because it's the standard. Translating between standards is a pain in the butt. When standards compete, one tends to win and the others go away. Sayonara, HD-DVD. In Sven's world, money is palladium. Gold is an exotic industrial metal, sometimes used for plating speaker cables. There is no one who wants to trade gold for salmon or Cadillacs for gold.

The basic problem with Menger's approach, from my perspective, is that he's concerned with the historical origin of money, whereas I am concerned with its logical origin. What Menger wanted to know is how money actually happened. What I want to know is how it can happen.

So: clearly, in the actual historical context in which money originated, the coincidence of wants was a serious problem, and Mengerian effects would no doubt appear. On the other hand, in Nitropia, with its advanced teleportation technology, barter is a trivial problem. If Sven wants to use gold as his I, and he finds a salmon buyer who has nothing but palladium, no problem. He trades salmon for palladium and palladium for gold, and he is there.

Wall Street is not Nitropia. Financial engineering is nifty, but it can't teleport bullion. But Wall Street looks a lot more like Nitropia than either looks like, say, ancient Greece. If we are concerned with the gold market today - and why shouldn't we be? What is economics, touch football? - Nitropia is probably a better model.

And it is a fact that even in Nitropia, as long as there are fish which don't keep and fishermen who want to retire, the MTP makes sense. Which means any Nitropians who practice the MTP must select some intermediate good I. And since the coincidence of wants is not a problem in Nitropia, Menger's analysis cannot apply.

Thus we see that Menger did not find the origin of money. He found an origin of money. That is, he found one way of breaking the premonetary equilibrium - eliminating teleportation - which could trigger one process of monetary standardization. Menger's analysis does not and cannot show that the coincidence-of-wants effect is the only force that can result in standardized money. Perhaps there is another? Indeed there is.

Back to Sven. Suppose that Sven can select any intermediate good I he wants - for any I, the transaction cost of exchanging salmon for I, or I for a Cadillac, is comparable. He is not bound in any way by the monetary preferences of salmon-eaters or Cadillac-makers. His choice is truly his own - or so it seems. So how does he choose?

The question is a little open-ended. Let's narrow it down. Suppose Sven is choosing between only two possible intermediate goods - Ia or Ib. Say Ia is palladium, and Ib is rhodium. What is Sven's algorithm?

It's actually quite simple. All Sven cares about is the change in the exchange rate between palladium and rhodium, across the time window T1 - T0 of the transaction. If (Ia/Ib)@T1 is greater than (Ia/Ib)@T0, he prefers palladium. If it is smaller, he prefers rhodium. In other words, he will prefer the I which will appreciate more across his monetary time window.

Of course, this has to be adjusted for storage costs and financial returns. If there is a financial market denominated in rhodium, and rather than keeping his rhodium under the mattress Sven can lend it out for a secure 3% rhodium-on-rhodium return, this is part of appreciation. If palladium is radioactive and needs to be stored in an expensive lead-lined chamber, effectively consuming 2% of its weight every year, the same applies. But even with this 5% difference, if the palladium-rhodium exchange rate is rising at 10%, Sven goes with palladium.

But how does he know what the exchange rate will do? He doesn't.

(Even a futures market cannot solve Sven's problem for him. Futures markets are notoriously bad at predicting exchange-rate fluctuations, because loan markets simply transpose future price fluctuations into the present. The gold futures market, for example, cannot predict rises in the gold price higher than the cost of borrowing dollars: otherwise, arbitrageurs can borrow money, buy gold, sell it in future, and collect the differential between the predicted price rise and the dollar interest rate. In fact, this would be a beautiful way to suppress the gold price, if not for that "buy gold" step.)

All Sven can do is think. And this is where the game theory comes in.

If Sven is thinking rationally, which admittedly is a big if for anyone named "Sven," he will realize that he is not the only Sven in the world. Whatever intermediate good he chooses, someone else will choose it as well. If there's one Sven, there's a herd of Svens.

And since buying and selling any good cannot fail to affect its price - ie, its exchange rate against other goods - we have a feedback loop. The herd selects an intermediate good based on its predicted exchange rate. But the exchange rate cannot be predicted without knowing the herd's selection. Problem!

Imagine the market for palladium, before the entry of this herd. Since palladium is not being used as an intermediate good, everyone who owns palladium has some actual use for it. Suppose, for simplicity, that this use is destructive - perhaps palladium is eaten, like wheat.

It is very easy to describe the pricing of wheat. Wheat is correctly priced when the price is such that wheat demand equals wheat supply, and wheat stockpiles neither grow nor shrink. Perhaps you've seen Wall Street stories about commodities markets in which inventories are said to be rising or falling. Commodities traders use these reports to guess whether the price at present is too high or too low. If they're right, they profit, if they're wrong they lose.

But why should wheat stockpiles neither grow nor shrink? Because no one wants to stockpile wheat. In other words, because wheat is not a monetary good (for one thing, it doesn't keep). In fact, if wheat was not a seasonal crop, it would probably be produced under modern just-in-time supply chain discipline, with almost no stockpile at all. Since it is a seasonal crop, it has some optimal stockpile. But it's certainly not 60 years of production.

This is why the normal techniques of commodities valuation strike out when applied to monetary goods. They are relying on an assumption that just isn't true. If the size of the stockpile is not controlled, there is no point at which "supply equals demand." Jessica Cross and her ilk are trying to solve for one variable in a two-variable equation. They might as well be reading tea leaves.

A fellow named Shayne McGuire, whose main claim to fame is that he's not a traditional goldbug at all but actually a state pension fund manager, has just put out a new book with the charmingly blunt title Buy Gold Now. I haven't read it, but I skimmed it a little on Amazon and it looks pretty good. In this interview, he expresses the difficulty well:
Any MBA holder, who has been taught to value almost any asset, hits a stone wall when faced with gold: it pays no dividend or coupon, and without deriving a cash flow, the basis of most assets defined as being financial, there is no conventional way to determine its dollar value.
Indeed (except that I would say "there is no conventional way to predict the exchange rate between gold and dollars.") You cannot calculate it as if gold was a stream of future dollar payments, because it isn't. You cannot calculate it assuming that the gold stockpile needs to converge on a constant, because it doesn't.

But Sven - if his Ia and Ib are not platinum and rhodium, but gold and dollars - has to compute exactly this number. How in the heck does he do it? Or does he just close his eyes and guess? Let's go back and look at the feedback loop again.

First, we need to establish that Sven's problem is indeed (as I claimed earlier) a coordination game. In other words, Sven's goal is to pick the same intermediate good that everyone else picks. Why?

Because of herd effects. There are two cases to consider. In case A, Nitropia has not yet chosen a standardized currency. In case B, it already has.

First, case A. Nitropia is just emerging from the premonetary equilibrium. All goods in Nitropia, including both palladium and rhodium, are priced as industrial commodities - ie, they are demanded only by direct users. Suddenly, a software upgrade introduces fish, thus motivating the MTP, thus generating a herd of Svens.

Let's separate this herd into two strategies, by eye color. If Svens have blue eyes, they follow their proper MBA reflexes and diversify, buying equally priced lots of palladium and rhodium. But if they have brown eyes, they buy only rhodium.

Who does better? The brown-eyed Svens. Why? Because the MTP has created new demand for both palladium and rhodium. There was no monetary demand before we broke the equilibrium - now there is. Ceteris paribus, the price must go up.

But we've created more demand for rhodium than for palladium. Thus, ceteris paribus, rhodium will appreciate against palladium. And thus the brown-eyed, undiversified Svens will wind up with more pimped-out Caddies.

In fact, it is even uglier than this. Because if we then relax the eye-color constraint, a substantial percentage of blue-eyed Svens are liable to say the hell with it, and ditch their palladium. To buy rhodium. Thus shoving the palladium-rhodium ratio even deeper into the dumps. There is only one end to this game.

Nor is this the worst. The worst is that, before the palladium-rhodium wars end, with the victory of the rhodium bugs and the obliteration of the palladiumheads, palladium had its little moment in the sun. Its price, too, rose above the level at which supply equalled demand. It built a monetary stockpile.

And now that palladium has been demonetized, there is no need for any such stockpile. Which means that it needs to be worked off. Which means the palladium price will actually fall below its original industrial-commodity level. Ouch! Taste the pain, palladium lovers.

Monetary competition is definitely not for sissies. At least in terms of the abstract economics - we'll get to the reality in a little bit - there is no stable inhomogeneous strategy. All the Nash equilibria are Highlander outcomes: there can be only one. But which one? Ah, that's the fun.

Case B, in which rhodium has already won, confirms our suspicions. Essentially, once there is one monetary standard, there is no need for another.

Once Nitropia is on rhodium, anyone who buys palladium is no different from anyone who is trying to manipulate any commodities market. In a free market, if you want to buy up a bunch of palladium - or wheat or oil or FCOJ - and by so doing raise the price, you may do so. But if you want to actually realize your profits, you have to sell at some point, and there is no reason to think you'll have any luck getting out at a higher price than you got in at. This is called the "burying the corpse" problem, and a thing of beauty it is.

In other words, money is the bubble that doesn't pop. Once rhodium feels the Quickening, any other potential monetary standard is at an incurable disadvantage, because its adherents are mere manipulators. Sooner or later they will get tired and let their guard down, and rhodium will take their heads. But rhodium itself cannot pop - there can be only one, but there has to be at least one. And that's money.

I am not an expert on monetary history, but my general impression is that, while until the late 19th century both gold and silver were monetary metals, places and times in which both gold and silver circulated amicably were rare. For example, China and India were generally silver areas, whereas patches of Europe fluctuated between silver and gold. Since Gresham's law will drive one of the two out if a ratio is fixed, since distributing floating exchange-rate quotes to every cash register was not exactly a practical technology, and since the noncirculating "good money" was generally exported to a region where it was a current medium of exchange, it was hard to avoid any other result.

In the Victorian era, however, the financial system became global, and gold crushed silver much as described above, leading to a worldwide (if very imperfect) gold standard. Silver holders got the shaft. Ouch. (In retrospect, if the US had gone to free coinage of silver, instead of walking the yellow brick road to the cross of gold, we might not have some of the troubles we have today.)

But wait - we have imported an implicit assumption. Why does Sven have to pick a "precious metal?" What makes gold, silver, platinum, palladium and rhodium "precious?" And why does his medium of intertemporal exchange have to be a metal at all?

Well, obviously, it doesn't. Most of us store most of our assets in artificial currencies, or assets producing flows of same (stocks, bonds, subprime AAA CDOs, etc). Clearly, defining Sven's problem as the choice of one of the five major precious metals makes it far too easy. Nor have we described the factors that govern competition between the metals.

We know that I has to be storable. Salmon are out. Definitely out. So let's start from there. Suppose our herd of Svens chooses some other common industrial product which is storable - let's say, axes. How will axes do against rhodium? Can Nitropia somehow get onto the axe standard, and if so will it last?

In fact, axes cannot be used stably as money. The problem is that an axe, as an industrial product, cannot be stably priced above the cost of making an axe.

Probably, as our herd of Svens swarms into the axe market, there will be some hysteresis as the existing axe makers struggle to catch up with the new demand. But catch up they will. After the shock is absorbed, axes will experience no appreciation whatsoever. Moreover, when the Svens flood out of axes into some good that actually can sustain monetary appreciation, such as rhodium, the affair will go down in history as a horrifying "axe bubble." As with palladium, but much worse. The landscape will be littered with rusted-out axe factories, and people will be using axes as doorstops, tire irons, etc, etc.

What is the difference between mining rhodium and making an axe? The difference is that you can make as many axes as you want, and it is still just as easy to make more.

Rhodium, or any precious metal, can sustain monetary appreciation because its supply is restricted by diminishing returns. Appreciation causes the stockpile to increase. But as the stockpile increases, the easily mined deposits are mined out. There is no reason to think that the price will ever go high enough to preclude all new production, but there is no reason to think it can't, either.

Imagine if today's gold price increased by a factor of 10. Would it increase gold production? It certainly would. Perhaps the gold dilution rate might even get up to 5%, meaning 7500 tons produced per year, although if you know the gold industry this is hard to imagine. Higher prices would also stimulate new gold discovery, and gold underground is future gold. It is priced into the gold market through the stocks of companies that own mining rights, and this certainly must affect any dilution rate. Still, however, gold at $10K/oz or even $100K/oz would not come even close to looking like an axe bubble.

In fact, I doubt that either of these astronomical prices could get gold to the present dilution rate of the dollar. As I discussed here, there is no precise way to measure the number of dollars in the world, but perhaps 15% a year is a good rough estimate of the dilution rate. This number is very, very, very high for a currency. Imagine if 20,000 tons of gold could be mined every year. It would basically have to involve some kind of alien earth-moving technology. And how many years could you sustain it for?

Our first-order criterion for Sven is: do what everyone else is doing. Dilution rates are our best second-order criterion for figuring out what everyone else is going to do.

When predicting future exchange rates between rhodium and palladium, with the ceteris paribus assumption that industrial criteria will not affect the price ratio, our first-order concern is the quantity of savings that will flow into each metal. Since monetary demanders are not interested in the good itself - they purchase by value, not by weight, volume, etc - we can think of their bars of rhodium as shares in Rhodium, Inc.

In other words, what they have bought is a fraction of the global rhodium stockpile. New mining increases that stockpile. It obviously does not increase the size of your bars. Thus, if we discount industrial demand entirely, dilution is equivalent to evaporation. If the rhodium stockpile grows by 10%, ceteris paribus, it's as if 10% of your rhodium evaporated into thin air. Or as if storage expenses consumed 10% of its weight.

These second-order factors, like positive investment returns, help drive the herd's choice of currency. Is a 10% dilution rate sufficient to convince a herd to abandon an existing, successful currency? What about 15%? I don't know. Ask Dr. Bernanke. If there is any numerical procedure for predicting monetary herd behavior, I'm certainly unaware of it.

However, factors such as dilution rate need to be evaluated not just in the present, but all along the path that leads to currency fixation. For example, if it really would be practical to extract gold from seawater at $10K an ounce (which it wouldn't), gold would not be a viable global currency. If the entire global financial system migrated into gold, prices would certainly exceed $10K/oz. Therefore, gold would have no possibility of winning the currency competition. It would have no endgame, and anyone holding it now should probably sell.

On the other hand, gold's enormous stockpile makes it far more viable as a global currency than any other precious metal. Stockpiles of the platinum-group metals (platinum, palladium, rhodium, and the minor metals osmium, iridium and ruthenium) are much lower, as are silver inventories. This implies a much more dramatic price response to an influx of savings - but it also implies a much higher dilution rate produced by the influx. I doubt any mineable metal can exhibit any predictable response to a price increase of four or five orders of magnitude. Thus the PGMs, and probably silver as well, do not have a clear path to currency domination. Not that gold's path is in any way, shape, or form clear! But it is much clearer than anything platinum has to offer. And since there can be only one, clarity counts.

At this point we have reached a level of abstract precious-metals theorizing that is certainly well beyond anything any market is likely to assimilate any time soon. Herd strategies only work if the herd actually understands and applies them. Especially considering Wall Street's almost tribal antipathy to gold and goldbugs - perhaps Shayne McGuire is the harbinger of a trend, but if so he is very, very early - we are simply getting ahead of ourselves.

Despite the Highlander logic, I own both gold and silver, and if I had a convenient way to buy it I'd pick up some platinum as well. At present, Wall Street is experiencing a generalized surge of savings into commodities. As investors become more educated on the subject, this may sharpen into a generalized precious-metals surge. By the time you see any kind of game-theoretic decoupling between metals, it will be quite late in the game. Also, gold has a significant disadvantage, which McGuire mentions in his interview: it is the only metal which governments have substantial stocks of. More on this in a minute.

It's time to consider the metals' great competitors, the national or "fiat" currencies. ("Fiat" is in fact the correct technical word, but as a result of repetition by Ron Paul and the like it is starting to acquire pejorative connotations. Unfortunately, this will rub off on the complainers rather than the currencies. Power hath its privileges. "National" and "artificial" are both good words without any strong connotations. You can also just say "paper," which is no more than the truth. And if you like to wax nostalgic for the old Constitution, this essay by George Bancroft may put some fire in your belly.)

Now that we understand what money is, it's easy to see what the national currencies are. They are artificial precious-metal substitutes. Governments always dreamed of alchemy, and now they have it. Like so many youthful fantasies, the reality is not as once imagined, but it is reality nonetheless, and we have to live with it.

Probably the most interesting fact about paper money, and certainly the least understood, is the gradual nature of the transition from metal to paper. Not since the 18th century, in the heyday of the Amsterdamsche Wisselbank, has there been any major financial system on an undiluted metal currency. The so-called "classical gold standard" of the 19C, really the Bank of England standard, was at all times heavily stretched with paper, like bread in a meatloaf. The reason we no longer have anything called a "gold standard" is that, by 1971 when Nixon closed the "gold window," the connection had become so attenuated as to be absurd. It was less a meatloaf than a sort of meat-flavored Wonderbread.

How do you stretch a gold standard? Easily. Print pieces of paper that say "one (1) gram of gold." Compel your subjects to treat them as equivalent to gold. This is the original meaning of legal tender, a concept which is quite confusing without the historical background. If you like, you can back these notes with something, typically debts due in the future, perhaps with a small amount of actual gold to permit "redemption." Or you can just accept them in payment of taxes. The combination of term transformation and legal tender power effectively allows an infinite amount of virtual gold to import itself from the future, via a Rube Goldberg machine so complex that not one out of twenty of your subjects has any hope of understanding it.

Pure paper, without any fond memories of the barbaric relic, is a considerable improvement on the old Bagehotian trickery. It is actually the first step back toward gold. It is very hard to turn a meatloaf back into a steak. It is much easier to restore a true gold standard, with no musical chairs, financial time travel or other wacky hanky-panky, simply by migrating away from paper to gold. Throughout history, paper money has been a cyclical phenomenon, and simple irredeemable paper is the unskippable last step in the cycle.

As Wikipedia puts it:
The history of money consists of three phases: commodity money, in which actual valuable objects are bartered; then representative money, in which paper notes (often called 'certificates') are used to represent real commodities stored elsewhere; and finally fiat money, in which paper notes are backed only by the traders' "full faith and credit" in the government, in particular by its acceptability for payments of debts to the government (usually taxes).
This is Whig history in one sentence. In real history, phase three wraps back around.

Clearly, the fact that paper money has no intrinsic utility is no barrier to its success or stability. In any model of spontaneous currency standardization, whether Law's or Menger's, there must be some original demand for the currency. But any government worthy of the name can create demand where there is no utility. Simply order your subjects to pay their taxes in your national currency. If they don't, arrest them.

I think it's very clear that if there was a fixed stockpile of dollars in the world, as I proposed in this post, the unbacked paper dollar would outcompete all other currencies, natural or artificial, in very short order. Even holders of euros and yen would move their savings into the dollar. These currencies would depreciate rapidly and collapse. So would gold, which would become an industrial metal, and quite a cheap one thanks to its enormous stockpile.

In theory, the dollar is certainly capable of reversing its present losing trend against gold. In fact it pulled off just this trick in 1980, under the leadership of the brilliant Paul Volcker. Mr. Volcker is still with us, and if you start hearing noises about bringing him back, worry. Gold prices declined almost continuously for two decades after his victory.

But don't worry too much, because the Fed does not have the weapons it had in 1980. The main one being 20% interest rates, which went quite a ways toward both ending the monetary dilution of the '70s, and compensating dollar holders for what was left of it. Unbelievable as it may sound, the US economy today is a shadow of what it was in the '70s. As we saw in this latest cycle, it is so debt-laden that it cannot stand 5% rates, even though these are at least -5% when you adjust for dilution. 20% was bad enough in the early '80s. Today, you'd see feral children gnawing each others' bones in the streets.

In theory, if a government cannot control a coordination game (such as currency selection), it is not much of a government. Indeed, when you buy gold, this is precisely the proposition in which you are investing. The Western governments of 2008 are red-giant states: they are as large as they have ever been, but also as weak as they have ever been.

Why is the dollar weak? Why, when the US is running epic trade deficits, are interest rates going down rather than up? Why is the suggestion of a note supply limited by statute, a policy once followed quite effectively by this very same government, an impractical curiosity which does not represent any real threat to gold holders? Why, for that matter, in a time of currency crisis, are Americans allowed to hold gold and silver at all - especially through incredibly convenient instruments such as the precious-metals ETFs, GLD and SLV, which anyone with a portfolio account can use to switch their savings into fully-backed bullion? Why is a senior fellow at what Murray Rothbard used to call the "Rockefeller World Empire" appearing on NPR and touting digital gold currencies?

This, I feel, is the most important question for anyone considering buying gold. Why moon the bull? Why taunt the tiger? FDR faced a combined currency and banking run in 1933. He leaped the fence, broke half the financial contracts in the country, and took the metal back. It was illegal for Americans to own monetary metals for the next forty years. A very simple case of attack and counterattack. Normal politics at its finest. Could it happen again? Legally, sure. And yet something feels different.

The answer is just that FDR is no longer in charge. In fact, no one is.

No one observing the Western governments today can fail to be struck by a massive sense of sleepwalking. There is no unified consciousness or purpose behind their actions. Each of their decisions is an atom unto itself, made through an almost ritualized process by a large number of very intelligent, talented and ambitious people, whose abilities tend to cancel each other almost perfectly, leaving nothing but a chilling bureaucratic continuity.

The modern regime is unable to take basic defensive actions against an impending currency collapse, because it is unable to take any kind of thoughtful action at all. It is certainly unable to admit that it has made any kind of systematic mistake. Because it decided in the 1970s that gold and silver were industrial commodities, it legalized their holding as a kind of gesture of power. There were those in 1971 who thought the gold price would actually decline when Nixon closed the gold window, because now the demonetization was official.

But in the '70s Washington still had men like Paul Volcker, a financial Aetius, with true gravitas and real personal authority. Volcker's austerity measures were something now unthinkable in Washington - a judgment call. He decided to restrict the quantity of dollars and let rates do what they had to do. They did, and it worked. A kind of last gasp of Carlylean government, a Roman ambush of the Huns, doomed perhaps, but still brilliant.

Professor Bernanke is just that - a professor. He is a specialist in a framework invented to employ specialists. Computer science is full of these research empires, full of sound and fury, signifying nothing. Detaching your little subfield from reality is the easiest thing in the world. Reconnecting is almost impossible. First, you'd have to admit on your grant application that you'd been studying something other than reality. If that's hard in Berkeley, try Washington.

Google News does not show me a single recent mention of the word austerity, at least not used by an American with reference to American politics. Imagine if Barack Obama went around the country talking not of "change," but "austerity." "Yes, we can - tighten our belts." Impossible. He's more likely to invade France. So much for the Washington consensus!

The custodians of the post-1945 financial architecture, such as they are, have one weapon which they may still be able to deploy. This is their gold reserves, officially about 30,000 tons. Central banks hold gold so that they can exchange it for their artificial currencies, changing the exchange rate in their favor. Ie, so that they can dump it on the market and trash the price. This is simply a generalization of redeemable currency, in which all discretion is transferred to the bank. It is not a conspiracy. It is normal.

However, it is not at all clear that official gold reserve figures are anywhere near accurate. IMF guidelines have long encouraged central banks to report gold that is "loaned" or "deposited" on a single line with actual monetary gold. In other words, what the bank actually owns is not gold, but an obligation from another party to deliver gold. The real gold has almost certainly been sold, and the counterparty (typically a large domestic bank or foreign central bank) is - at least in theory - "naked short." And not feeling too good about it, at least not these days. This practice was a great way to make money in the '90s when the gold price was declining, and in fact may have been a major cause of that decline. At this point it is somewhat embarrassing. James Turk recently discovered that USG is in on this game, which doesn't look good at all.

The gold lending situation, for no reason I can discern besides basic accounting honesty (something USG is actually quite good at, as it plays into the natural CYA response) appears to be heading slowly toward a correction. If this actually happens, it will be very interesting to see how much gold is actually left. However, there is also a large market in gold options and other derivatives. A central bank has many weapons.

However, we keep running into the same problem: the red-giant state. If you assume that USG and its allies are ruthless and Machiavellian, they have many ways to defend their currencies. But if USG and its allies were ruthless and Machiavellian, they would not have a problem in the first place.

Take the recently proposed IMF gold sales. The gold to be (possibly) sold will not simply be dumped on the market with an auction, a la Gordon Brown. No, it will be shoehorned into the existing Central Bank Gold Agreement, under which European central banks sell 500 tons a year. Nominally, this is a restriction to avoid massive sales that would depress the gold price. Perhaps this was even the original point. At present, however, it appears to be an obligation to prevent the price from reaching escape velocity, an obligation onerous enough that the Europeans would not mind shuffling some of it off on the IMF.

And of course, no one even begins to admit that managing the gold price is the point. Perhaps they are even sincere about this. Why shouldn't they be? Why shouldn't the policies that once were ruthless and Machiavellian have become, after decades of the system believing its own PR, mere force of habit? If the central banks were really managing the gold price, don't you think they'd be doing a better job of it?

As I recently suggested on this RGE thread, there's a simple way to understand the gold market. Think of gold as an artificial currency. Imagine that it's the currency of a small European country, which we can call Goldenstein.

Every year for the last five years, the Goldenstein auro has appreciated by about 20% against the dollar. And that was before the crisis. If we annualize 2008 so far, it's more like a million trillion percent. I exaggerate. Slightly.

This means, of course, that the dollar has lost 20% a year against the auro. Now imagine that you are doing customer outreach for some Wall Street firm that is trying to appeal to Goldensteiners. Specifically, you are trying to persuade them to invest in dollars. Or stocks, or bonds, or any financial asset which produces revenue in dollars. How would you pitch that?

Now imagine that you're a bank in Goldenstein, and you're trying to persuade foreigners to invest in your small but happy country. How would you advertise this service? Would you even have to? Where would it stop? Why would it stop? How would it stop?

Of course, there is no Goldenstein. That is, there is no sovereign country whose goal it is to defend and promote the gold standard. There is no auro, just gold itself. The economics are all the same - but there is no army, navy or air force. Goldenstein may be small, but at least it has a police force with a couple of Glocks and some old bulletproof vests. Gold has nothing at all.

And yet gold, as we've seen, is an existential threat to the greatest military power in the history of the world, one whose legal and financial arms reach everywhere. No corporation can even think about making USG its enemy. What can it do about gold? Anything, if it wants. What should it be doing? Something, definitely. What is it doing? Pretty much squat, as far as I can tell. Perhaps the god has abandoned Antony.


Blogger Patrick said...

How did you calculate the 15% dilution rate of the dollar?

February 28, 2008 at 6:17 AM  
Blogger G. M. Palmer said...

Where is the tipping point? Is it possible or likely that the dollar can experience hyperinflation?

Moreover, if the holders of future dollars demand their dollars, why should USG pay if it promises to collapse itself?

And since this is unlikely, will the holders of future dollars ever demand such a payment?

Furthermore, if the purchasing of gold is self-limiting (i.e. if everyone tried to buy gold before the close of market today, the price would rise so friggin high that, at some point, people would stop buying [though of course not stop selling]), could there be a run on gold?

Also, since USG seized the assets of those Liberty Dollar people, should we not guess that they will take similar action towards any threatening currency?

February 28, 2008 at 7:15 AM  
Blogger Leonard said...

This comment has been removed by the author.

February 28, 2008 at 7:42 AM  
Blogger Leonard said...

Hmm, I thought John Law might be you, what with sharing your ideosyncratic taste for making up words.

On the gold price, gold can be created via atomic transmutation, and also extracted from seawater. In our earlier discussion, "Independent Accountant" threw out the figure $5-$15k/oz for seawater extraction. I cannot speak further on that one, but that USGS paper you linked does not appear to have any information. (?) Pursuant to the former thread, I computed energy costs, with cheap energy, of roughly $1800/oz for transmutation. Of course making a viable procedure would be much more costly, because there's radioactivity involved... still, optimizing extraction procedures is what engineers are for.

Both of these means of getting at currently nonviable/nonexistent gold appear to have production costs in something like the $5-20k range; thus, whichever is lower-cost would serve as a cap on the price of gold. In the long run, anyway. Short run it could go arbitrarily high.

I am curious why you say this would make gold non-viable as money. For one thing, these methods would take years to perfect. But also, they apply equally, so far as I know, for any choice of commodity elemental money. All elements may be atomically synthesized, given enough energy. All elements are dissolved in seawater, or at least any element you'd care to use as money.

February 28, 2008 at 8:12 AM  
Blogger Leonard said...

imagine that you are doing customer outreach for some Wall Street firm that is trying to appeal to Goldensteiners. Specifically, you are trying to persuade them to invest in dollars. Or stocks, or bonds, or any financial asset which produces revenue in dollars. How would you pitch that?

Well, this is easy enough. You just need to convince Goldensteiners that the investment you are touting does not gain most of its income in present dollars. So, bonds might be out, although there is the inflation indexed bond. (These gain value according to measured inflation, IIRC, and so would not keep up with real inflation.) But a stock represents ownership of a future revenue stream. Thus, so long as the dollar inflation rate is not high enough to cause economic collapse, presumably a corporation can keep increasing its prices and thus keep its revenue stream more or less in accord with inflation.

February 28, 2008 at 8:41 AM  
Blogger G. M. Palmer said...

It's no longer money because once it becomes cheaper to produce that to procure it can no longer hold value and, instead, becomes a commodity.

Think of it this way. Gold costs $20k/oz to produce from saltwater at current dollar values. -- What that really means is that Gold costs 3oz/oz to produce -- you have to fission 3 ounces of gold to make one from seawater.

The cost cannot go down because of the fluctionation of dollar v gold. The cost can only go down because of technological advances.

Once you can make 1 ounce of gold from .9 ounces of gold, you will instantly make an infinite amount (or as much as there is in the sea) becuase you can (if anyone has any doubt about this, play Magic the Gathering with a nerd who has some infinite mana combo).

And since you have made near infinite gold, you have devalued gold to a state that it is worth about the same as wheat or tapwater -- therefore eliminating its ability to be used as money.

February 28, 2008 at 8:45 AM  
Anonymous Lawful Neutral said...

Investing in gold stored elsewhere seems unwise to me. Aren't you then betting the whole financial system's headed for a huge disaster, but not one so huge that the people with the actual gold won't honor your pieces of paper? That strikes me as a narrow window; if you really believe it, why not cement your bullion behind a loose brick in the fireplace?

February 28, 2008 at 9:36 AM  
Blogger G. M. Palmer said...

ln --

completely agree with you. If USG and the western economy is all shot to hell and back, why is Zurich going to turn my slips of paper into gold?

Honesty doesn't trump profit for corporations.


February 28, 2008 at 10:21 AM  
Blogger Leonard said...

Gold costs $20k/oz to produce from saltwater at current dollar values. -- What that really means is that Gold costs 3oz/oz to produce

Gold is currently ~$950/oz. Thus, $20k/oz translates into 21oz spent to distill one from seawater. So I'm not sure where you are getting 3oz/oz. Obviously a lose either way, of course.

Once you can make 1 ounce of gold from .9 ounces of gold, you will instantly make an infinite amount

No. Nothing happens instantly; we're talking about huge capital investments here. And any gold you make adds to the supply, thus lowering the price. Thus gold drops in price to the cost of producing it, plus profit. As I said, this would be a cap in price, but I see no reason why this should prevent gold from monetizing, or staying monetized, just as the possibility of mining gold cheaply never prevented it from being money.

As for seawater, I read some more of the USGS report Moldbug linked, and according to it, seawater is no threat to the price of gold: "the gold dissolved in seawater is not an economic resource because it amounts to only 14,000 t of gold in 1.35 x 1021 liters of global seawater". 14000 tons, even if all recovered instantly, would only lightly dent the world's stockpile.

February 28, 2008 at 10:37 AM  
Blogger Byrne said...

Holding actual gold rather than gold contracts is also betting on a narrow window of outcomes -- how likely is it that the financial system will collapse so viciously that even 100% collateralized gold obligations are worthless -- but laws are still enforced? All you need is a week or so of rioting to distribute your gold to whoever has the most guns. I would expect a goldbug to also accumulate some firearms, as a sort of credit default swap on other means of maintaining property rights.

February 28, 2008 at 10:37 AM  
Blogger Alrenous said...

Between John Law, this essay, and Nick's,
I feel pretty educated about economics.

Notably, I also found John Law's style to be very similar to Mencius', until this essay where I got to study the differences side-by-side.

But you can see why we would be confusion after remarks like this:

"Ted Butler is a crazy man. You should know this. I'm a little crazy myself, obviously, so I don't say it lightly. But if you want to know what a crazy man thinks about silver, listen to Ted."

However, I'm not sure that your stock-scheme would be enough to prop up the dollar vs Goldenstein, which is I think what Mencius is trying to get at.

Take a good year for economic growth, where GDP grows by 6%.
To use John Law's terms, this is the levitation rate. In a completely hard currency regime, every dollar would be able to buy 6% more stuff this year than last.

Take the calculated inflation is about 7%, which is roughly what official statistics will tell you.

The debasement rate will be the total of these; 15% or so.

Naturally, neither of the source numbers are terribly accurate measurements, which is why the total is a rough estimate.

Your point about gold going infinite really impresses me. I never thought about it in MTG terms like that. I can only hope that you'll find my counterargument equally impressive.

Actually what we're trading here is basically energy for gold. Right now, the dollar cost of the energy is more than the dollar cost of the gold extracted.

If demand for gold increases, the price of gold increases relative to all other goods, including energy. Basically, the gold price of energy would drop drastically in a remonetization scenario, making extraction possible.

This would support some pretty tasty debasement, though, and it could easily drop gold prices back down to parity as fast as gold could be extracted.

(This part is basically what Leonard responded with, but longer.)

However, while this is interesting on a conceptual level, I think on a practical level the numbers we have are all wrong.

Gold is dissolved in seawater at a level we call 'insoluble.' To get a grasp of the kind of issues this problem creates, we also call gold 'nonvolatile.' Quite literally, if we can extract it from seawater, we can also extract it from the air in vaults. Can you imagine what that would mean?

Lawful Neutral / Byrne
I agree with Byrne. If the rule of law has broken down, your gold contracts are the least of your worries.

Despite this, if I had gold, I would wholeheartedly keep it at my house. And take it out and look at it. And say, "My precious..."

February 28, 2008 at 10:48 AM  
Anonymous zanon said...

Question -- suppose you want to shift some of your assets into gold, would you do it via GLD, or Vanguard Precious Metals and Mining Fund (VGPMX), or actual solid bars of the metal that you store in a safe somewhere (paying the vig to buy it retail, and then paying again to physically store it, and then paying the vig once more to get it back into the fiat currency of your choice).

If it's in anything other than actual physical bars, don't you run the same confiscation problems you have with fiat money?


February 28, 2008 at 12:39 PM  
Anonymous Michael S. said...

One point to be made about gold which has not been made here yet - except by reference to sea-water extraction and nuclear transmutation - is that like all mineral resources, there is gold in the earth that cannot be cost-effectively extracted until the price reaches some level.

When I was a boy my father took me fishing several times on a lake in Ontario, about 100 mi. north of the US border, near which was an abandoned gold mine. It had last been worked before World War II and had been closed down for lack of personnel once the war began and men went into the armed forces. After the war it was never re-opened because the then-official price of gold at US $35.00/oz. did not even afford the owners the cost of digging the ore out of the ground. To my knowledge it has never been re-opened. There must be many other similar abandoned workings. At some price even re-processing the tailings of previously worked ores will become profitable.

There's a curious aspect to the economics of extractive resources that I do not completely understand, and that is the reluctance of investors to pursue such opportunities.

During the '90s the fall of the market price of crude oil was due in effect to dumping of cheaply extractable and high quality light crude from the Middle East onto the world market. The protracted length of time during which oil was $10/bbl or less drove many marginal wells out of existence. I am acquainted with a Wyoming family that owned some. They would have been happy with $25/bbl., but could not even pay for the electricity to operate the pumps on their wells at $10. Now that the price of oil has risen to over $100 there is at last activity in trying to re-open capped wells. With oil, one does not simply turn the tap on again - often, the first step is 'shooting' the well with very brisant high explosives (liquid nitroglycerine was formerly used - I do not know what is now). If this fails or is not for some reason appropriate, the well may ne drilled deeper. These represent significant capital costs that will take time to pay for themselves if the flow of oil can be renewed, and are dead losses if it can't.

No such obstacles exist for resuming exploitation of abandoned gold mines, assuming there has been no subsidence of the old workings. It is a puzzle why there is not more such activity, unless the cost of extraction has risen more in recent years than that of gold - which is hard to believe.

I was amused to see leonard's and independent accountant's references to extracting gold from sea water. In 1673, Johann Joachim Becher, the mercantilist economist, alchemist to the Holy Roman Emperor, and inventor of the phlogiston theory, proposed such a scheme to the Dutch Republic. There is nothing new under the sun, save what has been forgotten.

February 28, 2008 at 3:08 PM  
Blogger George Weinberg said...

There's a major conceptual error here, which I think I've mentioned before: what's useful as a medium of exchange is not the same as what's useful as a measurement of value. It's true that if you're going to use something as commodity money gold coins are best and silver second best, but if you're going to use certificates as money, there's no reason their value has to be to be denominated in terms of gold or silver. Ideall their value should be denominated in units of more or less constant purchasing power. You cannot take out something like a 30 year mortgage if the purchasing power of your money units is going to wildly fluctuate in unknown ways.

It's possible for the returns on holding gold (in terms of purchasing power) to outperform productive investments for certain periods of time, but this is not and cannot be the normal state of affairs. During periods of stability, people will want to hold no more physical gold than necessary to fulfill their obligations.

February 28, 2008 at 3:37 PM  
Anonymous Lawful Neutral said...

Byrne -
You're right that canned food and shotgun shells would be much better investments in the case of total collapse, but real, solid gold is still infinitely preferable to certificates backed by gold in such a case. Gold hidden in the mattress is also just about as good as paper in any case short of total collapse.

February 28, 2008 at 6:21 PM  
Blogger Independent Accountant said...

If you want to buy 1 ounce Platinum coins, they are available. Milton Friedman told a story of something that happened during the Russian Revolution. As the inflation was raging, prices increasing 192,000 times during the revolution, suddenly the people, spontaneously, began using the old Czarist currency. Why? They realized the plates had been destroyed by Lenin so: NO ONE COULD PRINT ANY MORE OF IT. By the way, do not apologize for not being an economist. I think your grasp of monetary theory is much better than Helicopter Ben's (1590 SATs) who has a PhD.

February 28, 2008 at 10:06 PM  
Blogger Independent Accountant said...

George Weinberg:
Irving Fisher proposed a "compensated dollar" plan in 1912. Such plans have been floated for a long time. They have all failed as "inflation" keeps being redefined. You can buy commodity index futures as an "inflation hedge" if you want. Having seen these things in practice, my response, follow George Bernard Shaw's advice in the "Intelligent Woman's Guide", get gold.

February 28, 2008 at 10:15 PM  
Anonymous Anonymous said...

you are an idiot

February 28, 2008 at 11:34 PM  
Blogger G. M. Palmer said...

I have a hard time believing that MM isn't John Law. The thought proecesses and writing styles are markedly similar.


February 29, 2008 at 7:34 AM  
Blogger TGGP said...

MM sounds very similar to "John Law". Both this post and the one linked to were quite good. The actual John Law's "Real Bills Doctrine" is still being promoted by Mike Sproul, who ocassionally pops up at the Mises blog.

Independent Accountant, the same thing happened with the old Iraqi currency.

Blogger at the Austrian Economists Steve Horwitz discusses the gold standard and history here.

February 29, 2008 at 9:17 PM  
Blogger Independent Accountant said...

Thank you. I was not aware of that.

March 1, 2008 at 6:08 AM  
Blogger ravinenator said...

Even if the dollar is doomed, why does that mean gold would win? It seems to me that the most similar historical moment is the replacement of the pound with the dollar as the world's "reserve currency". If that is the model, the euro, the yen and the yuan are the most threatening competitors to the dollar - not gold. Paper money defeated gold in the past. Why wouldn't "better" paper money defeat gold in the future?

March 3, 2008 at 4:33 PM  
Blogger TGGP said...

In what previous cycles has paper money failed and been replaced by precious metals?

March 3, 2008 at 8:37 PM  
Anonymous nick said...

A wonderful analysis, but flawed. I have responded at length here.

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January 9, 2009 at 1:27 AM  
Blogger  said...






January 15, 2009 at 8:50 AM  
Anonymous Anonymous said...







January 21, 2009 at 12:04 AM  
Anonymous Anonymous said...

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March 2, 2009 at 10:08 PM  
Anonymous Anonymous said...

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March 2, 2009 at 10:09 PM  
Anonymous Anonymous said...


March 6, 2009 at 6:01 AM  

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