THE GOOD, THE BAD, THE UGLY
by Frank Giustra
If you think you have seen this movie before, you are right,
since this movie has played time and time again throughout
history. Other than regular changes to the names of the
currencies and the nations, the movie usually ends much in
the same way.
Our protagonist, gold ("The Good"), prevails in the end,
while as the antagonist, the U.S. dollar's ("The Bad") fate
is sealed from the start. And what would a movie be without a
sidekick, in this case the American Government ("The Ugly"):
an often-misunderstood character whose unpredictable actions
inevitably have an impact on the outcome of the fortunes of
the two central characters.
Unfortunately, the lesson in this story - the US dollar's
unfortunate fate - seems lost with most people today.
There are a multitude of forces at play behind the current
bull market in gold. So, I think it misleading, that so much
attention is given to the daily gyrations of the gold price,
which in turn takes focus away from the true nature of the
forces behind this bullish trend.
Commentators, both bulls and bears, are quoted daily on the
reasons for that particular day's price move. Invariably,
most attribute the recent moves to either the fear of a messy
war with Iraq or the dissipation of those fears. My reaction
to all this daily noise - is to ignore it. We are in a
secular bull market in gold that is driven by macro-economic
events that have little to do with the immediate Iraqi
situation. This trend will continue for a number of years,
and while the daily ups and downs of the gold price may make
bulls suffer anxiety and give the bears opportunity to
declare the end of the bull market on a regular basis -- the
trend is clearly up.
Remember, every bull market, whether it's in stocks, bonds or
gold, "climbs a wall of worry" in the early stages and it
never goes straight up. In addition, gold is especially
volatile given its lack of liquidity compared to other
financial assets. As an example, witness the 1970's gold
market, which I believe bears many similarities to the
current market. It took ten years of dramatic ups and downs
before it eventually climaxed with an $800 gold price in
1980.
Gold is the chicken soup of all economic maladies that ail
the world. It has taken many years and plenty of abuse to the
system to create the necessary environment for the major gold
market we are now seeing. The gold price will continue to
move higher as the effects of that abuse are recognized and
fully understood. The corrective process will be beyond what
most people are prepared for. In the end, the standard of
living most Americans took for granted will be lowered
significantly. The structural deterioration of the system is
the end result of such things as an aftermath of a stock
market bubble, unprecedented high levels of public and
private sector debt, and a U.S. currency whose meteoric rise
and subsequent abuse allowed it to permeate into every
financial corner of the world.
So although factors such as declining primary production
(2002 gold production fell for the first time in seven
years), ever increasing de-hedging policies by gold producers
(hedge books contracted by 423 tonnes in 2002, almost three
times as much as the previous year), a forty-year-low
interest rate environment and its re emergence as a preferred
asset class (with the underperformance of financial assets,
gold purchases for investment purposes more than doubled from
2001 to 2002), will continue to help the gold price move
higher, gold's status as a currency and store of wealth will
be the driving force behind its long-term upward trend. Since
gold and the dollar have a historical high inverse
correlation, the degree to which the importance of the U.S.
dollar waivers or falls, will have a corresponding positive
effect on the price of gold.
I am fairly sure that the folks who brought us such religious
ideas as Judaism, Islam and Christianity, did so with the
best of intentions. The eventual success of these religions
made them so powerful, that the temptation to abuse them was
too much to ignore. Similarly, the folks that created the
concept of fiat currencies also had the best of intentions as
they attempted to smooth, and perhaps even eradicate, the
business cycle. But, as with religion, the tremendous success
of the currencies, which have represented all of history's
global powers, also begged for abuse.
For a number of reasons, the U.S. dollar has achieved such a
dominant status as the premier global reserve and transaction
currency, that its abuse as a tool to exercise power goes
barely noticed.
By all measures (as against other currencies and commodities)
it is evident that the dollar is loosing ground..but why?
There are many reasons, but in general terms, abuse by U.S.
policy makers and citizens alike, allowed it and the system
backing it to get so corrupted, that spooked foreign dollar
holders began switching into other currencies and gold.
Let's recap in more detail - the U.S. was the recent host to
the greatest stock market bubble in history, which burst
three years ago. Even so, like the villain in a B movie, the
U.S. stock market continues to resurrect no matter how many
fatal blows it receives by way of bad news. Consumers,
government and corporate debt have grown to levels totaling
well over $30 trillion with only corporations showing any
recent signs of restraint. Consumers, the worst offenders,
continue to pile it on - having increased their debt load by
500% in the last twenty years and are continuing to borrow at
a rate which is ten times faster than Gross Domestic Product
growth. For its part, the government, having doubled its debt
load to $6.4 trillion in the past ten years, borrowed an
additional $750 billion in the past eighteen months alone.
Also, short-term interest rates are at forty-year-lows,
allowing for nothing more than further speculation in stocks,
bonds and real estate, while the widening real interest rate
differentials are potentially disincentivizing foreign
purchasers of U.S. government debt. Throw in America's
aggressive foreign policy (which will help push the federal
deficit to almost $500 billion this year), the Fed's threat
to print money as a means to avoid deflation and an annual
current account deficit representing 5% of Gross Domestic
Product - it doesn't require much imagination to see why
foreign holders of dollars may soon look to the exits.
Let's look briefly at all these factors, starting with the
stock markets. Even though the bubble burst three years ago
and equities are off between 30% and 75%, depending which
exchange they are listed on, it's still hard to justify
current valuations. With the S&P 500 trading at thirty times
earnings it's hardly a steal.
Worse still, if one factors in the current reality of rising
energy, insurance and health care costs (which have all
increased dramatically), pension plan losses (once reality
replaces the current policy of reporting fictional gains),
excess capacity, lack of pricing power, declining consumer
demand and how all of these factors impact corporate profit
margins, the "E" part of P/E (price to earnings) forecasts
suddenly become suspect.
As in the last couple of years, after barely hitting recently
downgraded earnings, corporations are ratcheting down their
earnings guidance for the rest of 2003, and as usual the
analysts are ratcheting down current quarter market forecasts
and back loading the higher growth in the third and fourth
quarters. With economic indicators such as ISM (Institute for
Supply Management), factory orders, retail sales and initial
jobless claims worsening, I wouldn't be surprised if we don't
soon double - dip into recession, foretelling a further drop
in earnings.
So why are equity valuations so high? The Fed's continuing
easy money policy fuels the fire, I am sure. And for some
reason Wall Street strategists and economists continue to
retain credibility with their wacky market and economic
growth forecasts. But, I think it has more to do with a
change in investors' attitudes and perceptions. For years, a
pervasive media and the spin meisters - who know how to use
it, have shaped these perceptions. CNBC in my opinion is the
biggest purveyor of optimism in the market place, although
they are not alone. You would think it might be difficult to
consistently put a positive spin on an endless string of bad
economic data.
But by a combination of what appears to be selective emphasis
(i.e. no repetition or follow-up on bad economic news and
repeating the trivial stuff ad nauseam) and allowing
"industry experts" (who all have an interest in keeping
investors in the game) to comment and opine on the data, and
finally switching to sports and entertainment news on days
when the economic news is particularly bad, investors never
have a chance to do the right thing..and panic. Instead,
investors feel obliged to pile into overpriced stocks with
the tenacity of a pod of pilot whales beaching themselves.
As for CNBC, who knows, maybe its parent GE will recognize
this winning formula and license the format to foreign
territories suffering with sagging stock markets in need of a
boost.
Irrespective of all this hype, equities will inevitably come
down to earth. The effect this will have on the dollar will
be very negative, as approximately $1.5 trillion worth of all
U.S. equities are foreign owned. Consider what must be the
growing disappointment of, say a European, whose U.S. equity
portfolio may be down a nominal thirty percent or more, but
is actually down over forty percent in his home currency
terms.
At some point he will cut his losses.
That said, it is always difficult to predict short-term
market performance and with all the liquidity currently being
pumped into the system, it's quite possible that the U.S.
dollar will decline against the backdrop of a stock market
rally.
With regards to the debt situation, foreign lenders who own
over 40% of U.S. government debt, 23% of U.S. corporate bonds
and over 20% of mortgage debt must, by now, be waking up to
the fact that the U.S. is a nation of savings-deficient,
debt-hooked consumption junkies. Furthermore, it is governed
by an administration that is hell-bent on creating $1.8
trillion - according to the Congressional Budget Office (CBO)
- of deficits over the next ten years. It may end up even
higher as it looks as if current budgeting of U.S. Social
Security benefit costs will prove totally unrealistic. Just
two years ago the CBO projected a $5.6 trillion surplus in
the same period. One might think this kind of swing would
raise some eyebrows in the global currency markets.
But, if history provides any clue, it is that eventually
there should be a "tipping point", when the creditworthiness
of America will come into question. It is impossible to guess
when that day will come even though the cracks are beginning
to show. At best we will see a decade-slow deterioration of
America's creditworthiness accompanied by continued dollar
devaluation and, at worst, outright panic followed by an
Argentina-style (they also had a lack of domestic savings
when foreign lenders cut them off) dollar collapse.
There is no doubt that currently America is the most dominant
economic and military power on earth. Although the world has
seen many great powers come and go, including the Spaniards,
the French and the British, America's influence in all global
matters, whether economic, military, technological or
cultural, is a phenomenon the world hasn't seen since the
Roman Empire.
Sadly, the mistakes that brought about the economic demise of
all the past global powers are being repeated with impunity
by America's government and citizens alike. When confronted
with these historic similarities, most Americans will likely
dismiss the danger, convincing themselves that their current
superiority is deserved and permanent. They believe that
their system is so advanced and sophisticated that policy
makers will always manage to keep things under control.
Even when the system shows signs of strain; they all work
feverishly to spin the information such that the masses do
not panic. This game of confidence (or otherwise known as a
"confidence game") will continue until something gives. For
their part, the masses are happy for the reassurance, even
though their gut may tell them all is not well. Since most
people can only relate to their own lifetime experience, they
will believe when told that the current malaise is a run-of-
the-mill recession. Very little attention is paid to the fact
that the current system has structural flaws that have
deteriorated over the last three decades. These flaws are
worsening in an exponential fashion, and still we would
rather believe that this is a garden-variety recession that
can be remedied with the traditional tools of fiscal and
monetary policy.
It is becoming increasingly evident, to some at least, that
these policies are not working this go around. When a system
is overloaded with debt and over capacity and there already
exists a gross imbalance between consumption and production,
no amount of monetary or fiscal stimuli (which are meant to
inspire demand) will work. Conversely, it makes the situation
worse by fueling asset speculation and increasing public and
private sector debt.
Looking back, it is difficult to argue that, historically
speaking, America was initially a great experiment. The
American standard of living is the envy of the world and was
achieved by a combination of a political system that allowed
and rewarded success by anyone regardless of class, and by a
puritan work ethic that didn't exist elsewhere. Both these
characteristics held true for most of the 20th century and
started to deteriorate only in the last several decades. This
path to economic perdition was a result of an ever-increasing
societal shift from production to consumption, and by
transformation from a nation that was once the number one
creditor to the world to one of being the number one debtor.
Americans are holding on to their standard of living not as a
function of their productivity, but at the sacrifice of the
family unit (since it now requires both spouses working to
maintain a standard that forty years ago took only one), and
at the expense of their own future generations (as the result
of the increasingly heavy debt load), and at the expense of
the rest of the world (a function of its record and ever-
growing trade deficit).
How long the world's other 5.7 billion people will continue
to trade their products and standard of living for U.S.
dollars is anyone's guess, but I suspect that with the
Current Account deficit running at $500 billion per year (and
expected to rise to $600-$700 billion) and the U.S.
government's printing of dollars and issuing debt at historic
proportions, it won't be for long.
The ever-increasing government fiscal deficits are the result
of a system that refuses to sacrifice consumption while its
government embarks on a military adventure to reshape the
world in its own image. It has to be a historical precedent
that a debt-laden government goes to war and proposes to cut
taxes simultaneously. Keep in mind that the CBO forecast
mentioned earlier does not include the cost of waging a long-
term war on all that is anti-American.
Government deficits can only be satisfied by borrowing from
either its own citizens (an indirect form of taxation) or
from foreigners. Already foreigners own over 40% of the $6.4
trillion in government debt. Add to that the projected
accumulated deficit of at least $1.8 trillion - I believe it
will be a much higher number, given this year alone the
deficit could reach $500 billion - over the next decade plus
borrowing for other "capital expenditures" and the total debt
becomes a whopping number.
Then assume the same ratio of foreign holdings and it becomes
apparent that the U.S. will have a difficult time servicing
that debt, never mind ever paying it back in anything
resembling current dollars. Of course, the alterative
solution is to inflate the debt away by printing more
dollars, which is exactly what the Fed has already threatened
to do to stave off looming deflation.
Conveniently, the government would repay the debt in dollars
that would be worth a lot less than today's dollars. Again,
there is nothing new in this little game. Every global
powerhouse in history has played the same game. What is
amazing though, is that judging by the dollar's current
value, it seems that very few foreign dollar holders have
fully caught on.
God help America the day when everyone catches on.
Regards,
Frank Giustra,
for The Daily Reckoning
THE GOOD, THE BAD, THE UGLY Part II
By Frank Giustra
The current situation with Iraq does not bode well for the
future economic well being of America.
Firstly, now that the coalition has declared military success
it will only mean the end to the easy part of the entire
exercise. The administration of Iraq under the auspice of the
U.S. military and the effort to create a functioning democracy
may end up being a long and bloody exercise indeed.
History has shown that the Middle East does not respond well
to occupation by the West. From the Crusaders to the Brits,
the eventual outcome is always an exhausted retreat. Trying to
impose democracy on a region populated by a multitude of sects
and tribes that all hold grudges that go way back (in some
cases more than a thousand years) and was only held together
with totalitarian force, may be challenging to say the least.
Furthermore, given that the U.S. will have influence as to
which specific Iraqi groups and people will be allowed to
participate in this process, it will create further suspicion
and turmoil. Democracy is a concept that must evolve, with
groups of people that wish to live together and with a proper
institutional infrastructure in place. I doubt it can be
ordained at will.
Secondly, whatever is being promoted as the reason de jour
behind the invasion (oops, I mean liberation) of Iraq, i.e.
elimination of weapons of mass destruction, preventing state-
sponsored terrorism, regime change, the freeing of the Iraqi
people, etc., it is increasingly evident that there is a much
larger plan at play. Recent rhetoric suggests that once
America succeeds in replacing the Iraqi regime, its focus will
turn on other countries in the region. It's astonishing that
without even pausing for breath, once the Iraqi regime fell,
Administration attack-dogs Rumsfeld and Wolfowitz started
accusing Syria with the whole terrorism/sponsorship/WMD thing.
Iran may be next, and eventually even old friends like Saudi
Arabia may find themselves in need of an unsolicited American-
sponsored regime change. Also lurking and simmering in the
background is North Korea, which is preparing itself for some
type of confrontation with the U.S. Unless it can negotiate a
non-aggression pact (something a recently battle-victorious
U.S. is unlikely to give), it will continue to play its
nuclear hand.
How Iraq's Arab neighbors react to all of this is hard to
predict. For one, they certainly don't trust America's motives
and their rulers haven't done much to prevent recent public
outrage over America's attack on Iraq out of fear their
citizens will turn on them and partially to take the heat off
how badly they have run their own countries.
Ironically, many of the Arab countries are run by regimes
which would be deemed illegitimate by American standards but
who, nonetheless, are propped up by the Americans. In the end,
the rulers of these countries will likely keep a fairly low
profile while quietly rooting the U.S.'s occasional stumble.
Their enraged citizens, on the other hand, may eventually
behave less predictably and this is when the entire region may
turn into hell on earth. If at that point the Americans are
still in the region, it will become a bloody conflict beyond
what America is prepared for.
It is doubtful that the average American will choose to
sacrifice his standard of living once the combined economic
reality of the accumulated excesses and the costs of American
foreign policy collide. Sentiment will eventually parallel
that of the Vietnam era rather than say, WWII. Waging wars in
far off lands that pose no "immediate threat" while impairing
the comforts of daily life at home, have never succeeded in
popularity for long. I am not sure what will happen at that
point, but suffice to say, that America will be a less happy
place to live in.
The debate over current U.S. foreign policy will continue. I
will leave it to future historians to judge whether America
was acting in self defense and for the benefit of the
oppressed in need of freedom, or whether it was acting out of
economic self-interest. I will say though, that, "freeing the
world from evil" might be a long and expensive exercise. For
the purpose of this analysis, it only matters how much this
current adventurism will cost the U.S. economy and how the
rest of the world perceives Americas intentions. The magnitude
of the economic costs will negatively impact the U.S. dollar
and foreign perception may amplify its fall.
In the long run imperialism and over-consumption are a recipe
for economic decline. We only need to look back at the 16th
century Spaniards, the late 18th - early 19th century French
or the late 19th century - early 20th century British for
historic examples of countries trying to run concurrent war-
monging and consumption.
Of the three, the experience of the 16th century Spaniards
makes for the best comparison with the Americans of today. For
nearly 100 years immense supplies of gold and silver (the
likes of which Europe had never seen before), plundered from
the natives of Central and South America flowed into Spanish
coffers. Sadly, this 16th century version of excessive money
supply growth managed only to fuel the nations' spending
habits, while at the same time disincentivizing their
willingness to produce. Instead of turning this windfall into
productive wealth, Spain used it to buy "consumer goods" from
other nations. As a result, Spain's debt to foreigners soared
and all the gold and silver was exported out of the country
(think current account deficit without the ability to "print"
more gold).
With all this new-found wealth, it didn't take long for the
kings of Spain to think themselves superior and embark on a
mission of bending the world to their will. Charles V, not
satisfied any longer with being a mere king, lobbied
intensely, using bribes and threats and eventually convinced a
"coalition of the willing" to make him emperor of the Holy
Roman Empire. After loosing quite a few of its booty-laden
ships on the high seas, Spain, claiming self defense, declared
that it would no longer make a distinction between the pirates
and the nations that harboured them. To eliminate this "state-
sponsored piracy", they decided to strike at the worst
offender - Britain (although I doubt that Philip II ever
suggested that he was merely trying to free the British people
from oppression).
Boasting their technologically superior Spanish Armada (not
dissimilar to America's air supremacy), they waged what proved
to be a disastrous war against Britain whose smaller ships
proved far too wily. Years of wars ensued with a variety of
other countries that did not share Spain's view of the world.
Having already traded their gold and silver for consumer
goods, the nation had to turn to debt-finance to pay for these
wars. As Spain's tab reached the limit, their lenders, the
Fuggers of Augsburg (16th century version of the Japanese)
were forced to convert their debt into long-term loans.
Eventually, Spain's creditors cut them off and the nation, now
bankrupt, introduced to the world the now time-honored
tradition of default by a sovereign state.
Of course, in their time very few of the above mentioned
governments or their citizens would have ever believed such an
economic fate would befall them. I suspect most Americans
today wouldn't either. Truly amazing when one looks at the
current sad state of America's public and private balance
sheet and its voracious consumption appetite. For although
past global powers had their excesses, it took the Americans
to really put the "pro" in the term profligate.
So what has all this to do with the price of gold?
The current economic and geopolitical direction of the U.S.
will, unless corrected, lead to a long-term decline in
America's standard of living. How quickly all of this unfolds
is subject to many unpredictable factors. There exists a small
chance that this decline can be prevented, but that would take
political courage and economic sacrifice that just doesn't
seem to exist anymore.
It may take several decades for the collapse of the U.S.
financial system to occur or it could happen this decade. In a
few years we may witness a new bull market in equities
(although I doubt it) after this current bear market plays
out. That said, the current macro-economic trend and its
eventual outcome is undeniable.
Regardless how it plays out, there is one thing for sure. The
world is dangerously awash with U.S. dollars. In addition to
the previously mentioned levels of foreign owned U.S. debt and
equities, it's notable that more than three quarters of global
central bank reserves are in U.S. dollars. The downward trend
in the dollar began two years ago and is very much intact.
Although it has fallen approximately 25% against the U.S.
dollar index, it is still over valued and will most likely
fall a further 15% in the next two years alone. In the long
run it may go down a lot further. This bodes well for gold for
several reasons. Firstly, as gold is priced in U.S. dollars,
the dollar's decline will make it cheaper to purchase in other
currency terms and less attractive for non-U.S. gold producers
to produce.
More importantly, if its imperial status is severely
challenged and no other currency emerges as a viable
alternative (only two are sizeable enough, the Euro and the
Yen, and both have more than their share of problems), then
gold will regain its historical status as the currency of last
resort and the ultimate store of wealth. In this scenario, the
price of gold would reach levels never seen before.
Unfortunately, it seems most Americans are impervious to the
current economic trend, foolishly ignoring 2,500 years of
monetary history. A history which is littered with lessons
about the consequences of virtually every monetary and
financial phenomenon we are witnessing today. Excess debt and
consumption brought down every major power in history. Stock
market and other asset bubbles, whether they were speculative
manias (the tulip bubble of the1600's), market frauds (the
South Sea bubble of 1720), easy money bubbles (the Mississippi
Company of 1721), or bubbles caused by innovations (the canals
bubble of 1837 and the railroad bubble of 1873), all ended
with crashes and subsequent depressions.
We are all familiar with the economic aftermaths of the 1929
stock market crash and the more recent 1989 Japanese stock
market and real estate crash. Finally, "preemptive" wars and
other types of military adventurism are also nothing new and
the end result in economic terms is never very pretty.
Inevitably, a combination of these events is almost always
followed by subsequent currency debasements (as invented by
Dionysius of Syracuse in 400 BC and practiced regularly by
every major world power since, especially with the
introduction of paper money).
America will be no different.
It's only a question of time. Since none of us knows how long
before that day comes, I suggest that at the very least
investors should diversify out of U.S. dollars and hedge their
portfolios with at least 15% gold content.
As for the lesson in this story, unfortunately it will be
learned time and time again throughout history and our
protagonist, gold, will always be around to provide refuge
from man's inherent need to push things too far.
Finally, for those that read this and dismiss it as
apocalyptic ramblings, consider that all I predict is a
repetition of history, not the end of it. The day will come
when it will be prudent to sell one's gold holdings and invest
in paper assets. Furthermore, although corporate America may
be in decline, investment opportunities will always exist. And
if not in America, then in other parts of the world, perhaps
in emerging economic powerhouses such as China.
On the bright side, who knows, perhaps in 50-100 years, it
will be the Chinese who will play the "Ugly" role in our
movie.
Regards,
Frank Giustra,
for The Daily Reckoning