A baseline overview and a psychological, political, and historical approach regarding the emerging gold bull market
Part III of XI
BACK OF THE ENVELOPE ANALYSIS FOR $1,000 GOLD IN FIVE YEARS
To justify my $1,000 low-end price target within five years, I need to "run the numbers" and then explain the assumptions behind them. Here they are:
|THE QUICK CALCULATION:||Baseline||Estimated|
|Intra day price of gold on 16 March 2004||$400|
|Increase from current "suppressed" market price back to "equilibrium"||* 1.28|
|Impact of continued dollar slide/global inflation||* 1.28|
|Impact of continued M3 growth and accelerating price inflation||* 1.28|
|Impact of declining mining production||* 1.10|
|Increasing Asian and general investment demand for gold/commodities||* 1.16|
|Impact of increasing crisis instability||* 1.10|
I intend each of the above factors to be understated. Upon reviewing my assumptions, the reader will be able to see how gold could possibly rocket up to over $2,000 or $3,000 an ounce much sooner than five years. But before anyone gets too excited, let us examine each assumption in some detail.
As usual in the investment business, I have a duty up front to warn readers that market projections are inherently risky. There is always some chance that we could get blind sided by unforeseen factors and that gold could behave contrary to expectations. Conversely, it is also possible that the rise in gold could vastly exceed expectations.
Please be aware that what applies for gold in this article also applies to silver, which closed at a $7.53 an ounce on March 19th and has enjoyed a greater bull market in the last year than gold. I zero in on gold because it is the primary form of "natural money" that has been the main target of manipulative efforts. Silver, historically the second most natural form of money, has been a secondary target in support of campaigns against the main target gold.
INCREASE FROM CURRENT "SUPPRESSED"
MARKET PRICE BACK TO "EQUILIBRIUM"
Estimated increase factor: 5% a year or 28% cumulative total in five years
At the March 16, 2004 intra-day market price of $400 an ounce, gold recovered back to its 1996 level. It dipped to a low of $252.90 in June 1999. Can we assume that gold was at a reasonable market level in 1996, was artificially suppressed in the following years, and that now we can expect it to catch up to the inflation-adjusted level where it might have been without the suppression?
Gold prices in current dollars. [Source: GoldNewsletter, Feb 2004]
Inflation-adjusted approach from a technical or historical support base: At $400 an ounce in 1996, gold was fifteen years into a commodities bear market and had showed sideways technical trending evidence of "basing out." The inflation-adjusted gold price chart above supplied by the Gold Newsletter suggests that gold formed a base between 1993 and 1995 at roughly $500 an ounce in today's dollars.
In a 2001 article that looked at multiple valuation perspectives, James Turk used CPI increases from gold's $35 price in 1934 to determine that gold should be worth $463.
In his April 2003 article "The Gold Price," Paul Van Eeden extrapolated the price of gold adjusted for broad money supply M3 growth and gold supply inflation since 1947 and came up with a value of $700 an ounce.
Supply and demand analysis: Frank Veneroso, a consultant to central bankers, published the Gold Book in 1998, in which he estimated the equilibrium price of gold at $600 an ounce for 1996. In his analysis, he looked at supply and demand inelasticity and the likely market impact if central banks desisted from selling off gold to fill the 1,000 tonne supply deficit in 1996. The gold market has experienced significant supply deficits since 1987. The decline in gold to $252.90 in June 1999 was a major historic anomaly, given that countries tend to jealously guard their gold hoards as strategic assets, and also given that gold supply gaps usually foster higher prices until deficits are eliminated.
Dow/Gold Ratio vs. Tobin Q's Proxy [source: sharelynxcharts]
Gold vs. stock market valuation: Another equilibrium approach compares gold to trough valuations of the Dow. According to Reginald Howe in his Nov 1999 Golden Sextant commentary, "The Dow/gold ratio moved from 1.01 in 1897 to 18.4 in 1929 before the crash, then fell to 2.01 at the bottom in 1932 (gold fixed at $20.67/oz.). From 28.26 at the Dow peak in 1966 (gold fixed at $35/oz.), the ratio fell to about 3 at the bottom in 1974, and to 1.04 in January 1980 at the modern peak in gold. At the Dow's peak in August 1999, the ratio was over 40, an all-time high."
If we pick a ratio such as 3 from 1974, and assume a worse case scenario 72% fall in the Dow to 3,000 within five years from rising interest rates, this could imply $1,000 gold. This would fit older patterns if gold continues to play "catch up" during a continued asset price deflation credit bust cycle combined with simultaneous consumer price inflation.
The chart above, incidentally, is very useful for another purpose. It provides a graphic indication of the huge and ever growing boom-bust pulse surges of credit under the fiat money and fractional reserve banking system seen in America since the creation of the Federal Reserve Banking System in 1913. The Tobin Q Ratio that coincides with the Dow/Gold ratio above helps to validate this concept, since it divides the market capitalization of all companies by their replacement value. I will return to the topic of horrendous liquidity surges in a fiat money system in Part VI "The Propaganda War Against Gold."
Getting back to the inflation-adjusted Feb 2004 Gold Newsletter chart provided at the beginning of this section, if the growing pulse surge pattern repeats itself, and gold tops its last high in 1980, then we will likely see gold over $2,000.
650 Year Historic Gold Price [Source: Sharelynxhistorical charts archive]
Gold brought forward through a Purchase Power Parity Time Machine.
In the very long-term historical chart above, we see a tug of war between several factors. On the one hand, we see the price of gold drop due to a major supply shock involving gold introduced to Europe from the New World after 1492. Lesser price declines followed discoveries in California and South Africa. An even bigger erosive force has come about when governments have demonetized gold by effectively discarding various elements of a fully negotiable gold standard while inflating in times of war, such as during the Napoleonic Wars (War of 1812 for the US), World War I, and World War II. Conversely, gold gained in value during the period of the international gold standard of the 1800's combined with the gains in wealth created by the Industrial Revolution, when the world added wealth at a greater rate than miners could add gold supply. The source that created this chart claims the price of gold peaked several times at $627 an ounce during this period in 1998 constant dollars. The gold price in constant dollars also increased during periods of deflationary bust (the 1930's) and speculative demand (late 1970's).
In Part II of this series I described how the purchase power parity concept applies to international trade. Here we try to put gold through a time machine. According to economist Mark Skousan, a tailored suit cost the equivalent of an ounce of gold or $20.67 in 1933. According to Peter Brimelow in "Gold miners and Haberdashers" a tailored suit cost $1,260 in 1997 dollars. John Hathaway of Tocqueville Funds commented in Nov 2003: "According to Alan Flusser, renowned author and designer of exclusive menswear, a bespoke gentleman's Saville Row suit could be purchased in the early 1980's for around $800. Today, the number is over $3000."
We must deal with a number of complex issues in trying to adapt the purchase power parity concept through time. America had stable money under a gold-plated standard until the Federal Reserve was created in 1913. From then gold became continually marginalized and "demonetized" in various ways as the money supply grew rapidly. By the 1920's the official price of $20.67 an ounce had already become a kind of governmental and central bank "bluff" that did not reflect underlying money supply growth realities. Because the U.S. had gobbled up huge gold reserves from various World War I combatants while a "neutral" trading partner, in a bizarre way it was able to aggressively inflate the money supply and look strong in gold at the same time. In 1933 FDR confiscated gold from private ownership and then arbitrarily hiked the official gold price to $35.00. In 1971 Richard Nixon removed the dollar from gold completely. In 1974 private gold ownership rights were restored, but otherwise to this day gold has no fixed exchange relationship with the dollar, whose supply has been accelerating at historic rates. The price of gold per ounce as a purchase power parity yardstick in each of these periods has a very different meaning based on many social, political, economic, and monetary factors, to include ways that central banks can play with the price of gold through systematic selling and governments can reduce its negotiability through various forms of demonetization.
In addition, the purchase power parity approach does not necessarily factor in how the advent of new technology should make items cheaper. As mentioned in Part I of this series, an ounce of gold purchased twice as much in Britain in 1914 at the end of its prolonged gold standard era compared to ninety years earlier. Much of this gain related to production cost reductions from the Industrial Revolution. Perhaps an ounce of gold should buy at least two or three low end men's suits today compared to one a hundred years ago, whereas it may only continue to buy one low end luxury suit on the high end. As an example, today one can buy a low end Men's Warehouse Suit for $400. Do we double or triple this number to $800 or $1,200 an ounce for comparison purposes if it reflects a substantial input of modern low cost manufacturing methods or modern low cost logistical access to low cost Third World labor? But then again, in the chart above, if gold reached $627 several times during the gold standard era, and the real wealth of the world has grown much faster than the average 2% annual supply addition to the world gold supply during the 20th century, then why would not gold's true international value be some multiple of $627?
ARE THE FORCES OF GOLD SUPPRESSION IN RETREAT?
The topic of gold suppression is worth covering in some depth. This is because the degree of the effort and the extreme circumstances required to keep gold down helps to validate its baseline value in a negative way, much like the way a physicist who measures the force required to compress a spring helps us understand the power of its potential spring-back. We also need to address how gold and the dollar may have both been manipulated simultaneously, since the dollar and gold tend to move inversely to each other. (cf. my discussion of the so-called "Law of One Price" in Part II of this series). We also need to get a sense regarding how these same forces for gold suppression may now be running out of ammunition and may be in retreat, possibly allowing free market forces to push gold towards a much higher free market equilibrium level.
I believe that gold price suppression between 1996 and 2001 involved both "lucky" short- term events for the U.S. dollar combined with very real manipulative efforts to support an upward dollar trend and a downward gold trend. Today what were considered "virtuous circles" during that period have now turned into unwinding "vicious circles."
"LUCKY" EVENTS FOR THE U.S. DOLLAR
Paul van Eeden's April 2003 article "The Gold Price" describes how the dollar increased 120% from 1990 to 2000. One factor involved foreign capital pursuing America's 1995-2000 stock market mania. Van Eeden claims that flight capital was an important factor as various countries experienced currency crises. As examples, from 1994-95 the Mexican peso declined 50%, from 1995-96 the Japanese yen lost 24%; from 1996-98 during the Asian crisis the Indonesian rupiah lost 76%, the South Korean won lost 56%, the Malaysian ringit lost 40%, and the Philippine peso was down 40%. In 1998 the Russian Ruble was down 70% and the "new" Brazilian real collapsed. And on it went. In "Understanding the Gold Price" written in 2000, Van Eden claims that the Asian crisis caused various countries to sell gold to help defend their currencies, helping to knock the gold price down from 1997-1998.
TOOLS TO HELP "LUCK" ALONG
Jim Roger's article "For Whom the Closing Bell Tolls" explains how loose margin, credit, and monetary expansion policies by the Fed helped fuel the stock market mania, which in turn attracted foreign investment and supported the strong dollar. Loose lending practices by big money center banks helped create major mal-investments in Asia and elsewhere that set up many countries for crises. Hedge funds fueled by loose speculative capital then helped trigger currency crises for their own gain.
The Clinton administration wanted the world to view America as a safe haven, and had very powerful tools in its arsenal to help "spin doctor" this story. I discuss in my "Amidst Bullish Hoopla" article how the U.S. Government created the Exchange Stabilization Fund in 1934 to help "stabilize" currency exchange rates. Of course where "stabilization" turns into "manipulation" few people seem to notice or care. The U.S. Government created the "moral climate" to manipulate currency in conjunction with other markets, to include the stock and precious metals markets, with the creation of the Working Group on Financial Markets following the 1987 stock market crash.
Many different factors played an important role in the "lucky" 1990's. The US dollar comprised about 68% of global bank reserves. The U.S. remained the world's last "Global Superpower" after the collapse of the Soviet Union. The US comprised about 25% of global GDP and presented an enticing market for foreign exporters. Last, but not least, the US has maintained a hegemonic relationship with two of its major trading partners, Germany and Japan, since World War II.
The dollar and gold can have an inverse correlation with each other whether or not there is government or central bank intervention. Manipulation can muscle gold down a quantum level while it continues to zig and zag in short term trading movements relative to dollar futures. Put another way, a long term inverse correlation between the dollar and gold does not necessarily disprove the manipulation case.
EVIDENCE OF OUTRIGHT MANIPULATION
James Puplava described strong evidence of dollar interventionism in the first hour of his May 31, 2003 Financial Sense Newshour show "Pulling a Robert Rubin." Before becoming Secretary of the Treasury during the Clinton Administration, Robert Rubin had been a currency trader at Goldman Sachs and understood the psychology of the markets. Normally central bank interventions would buy enough dollars to arrest a dollar decline and then stop. Beginning in 1994 under Rubin, the buying continued to drive the dollar upwards and burned leveraged hedge funds. Puplava noted, "There was a clear message here, and this was the beginning of the strong dollar policy. They would sell gold and support the dollar, and that became the central focus...This has been documented at GATA's web site." On his show, Puplava frequently talks about "flag pole" rallies in which aggressive buying in futures pits involving index contracts are used to move markets at strategic moments.
Fraud note: It would not be out of character for American political leaders to manipulate markets or suppress important economic information to achieve short-term political goals. As an example, Pat Buchanan described hubris, gross irresponsibility, and a high level game of hot potato in his article "Bailing Out Brazil –Or Robert Rubin?." Because the Clinton Administration had heavily promoted the North American Free Trade Agreement (NAFTA), it had a strong political motivation to help bail out arch trading partner Mexico during the 1994 peso crisis. Major US money center banks with serious Third World debt exposure liked the way the strong dollar helped problem borrowers by encouraging US demand for their exports.
The Bush administration has swept growing Third World debt problems under the rug that it inherited from the Clinton administration because, as Buchanan puts it, "No one wants to be in the pilot house when the ship hits the reef." Incidentally, another monstrous debt problem that the Bush Administration is denying is the $44 trillion Medicare and Social Security liabilities "abyss" identified by Dr. Laurence Kotlikoff in his "Going Critical," article and also on the Financial Sense Newshour.
There are all kinds of political agendas we might come up with ranging from pork barrel re-election strategies to longstanding Neo-Con interventionist plans that could help explain who might benefit from gold suppression and an artificially prolonged "feel good" economic environment. More on motives later in this series.
There are currently three major areas that show ample evidence of gold suppression: The first is the Blanchard suit against Barrick and JP Morgan Chase. The second involves data related to aggressive central bank selling of gold hoards. The third involves commodities market manipulation. Let us briefly review each of these areas:
Blanchard & Company, the largest bullion dealer in America, filed a $2 billion suit in Dec 2002 against the major money center bank JP Morgan Chase and the senior gold mining company Barrick Gold alleging substantial client losses as a result of unlawful price manipulation, anti-trust violations and unfair trade practices.
The Blanchard case has now moved to the discovery phase. This is very significant for several reasons. First, it may make public hard facts regarding unlawful collusion to drive down gold prices. Secondly, Blanchard filed an injunction to force Barrick to cover its massive short position. If it wins its case, efforts by Barrick to cover its short positions could substantially move the price of gold. Lastly, the discovery process may shed light on the gold-derivatives related positions of JP Morgan Chase. Already JP Morgan Chase, one of America's largest banks, is believed by many experts to be leveraged at over six times its capital and to have the world's largest gold derivatives exposure. Many investors are worried that a sudden run up in gold prices could detonate a meltdown similar to the Long Term Capital Management (LTCM) fiasco in 1998.
Jay Taylor, who publishes J. Taylor's Gold and Technology Stocks, interviewed Blanchard & Co. CEO Donald W. Doyle for his 15 Dec 2003 issue. According to Doyle, JP Morgan Chase acquired a significant ownership position in Barrick through a third company called TrizecHahn. Barrick arranged an incredible deal where it can massively short gold without any margin requirements for a fifteen year term. On top of this, it can roll over its contracts indefinitely.
According to Doyle, at its height, Barrick accumulated a 23 million ounce short position, which amounted to five times the global investment demand for gold for 2000 and 2001 combined. This is also equal to the combined annual output of every gold mine in the world's two largest gold producing countries (the US and South Africa), or 80 times the speculative limits set by the COMEX (Commodities Exchange). Doyle claims that all of this was more than adequate to manipulate gold prices downward. Barrick allegedly treated its short positions as off-balance sheet assets and did not feel compelled to include fair market value changes in its current earning statements. It did, however, report $2.2 billion in additional revenue from its short sales. It also reported sixty consecutive profitable quarters of short-selling activity. An unbroken profit record like this is virtually unheard of in the volatile commodities trading world.
Significantly, Barrick unsuccessfully tried to get the case dismissed under the sovereign immunity theory claiming that central banks were involved. This points a finger at the Fed. Also, Doyle said that he thinks a price for gold of $750 an ounce is a reasonable inflation-adjusted number if the suppression had not taken place, particularly given that Barrick began hedging operations back in 1987.
CENTRAL BANK MANIPULATION
Central bank manipulation of the gold markets is an old story that goes back in recent history to the London Gold Pool episode of the 1960's. While promoting a guns-and-butter policy that involved simultaneously funding the Vietnam War and his Great Society social welfare programs, Lyndon Johnson wanted to avoid raising taxes at all costs. His administration created fiat money out of thin air and pawned off on foreigners over half the cost of the Vietnam War. (cf. the Mises Institute lecture: ."Presidential Money Mismanagement from FDR to Nixon" by Dr. Joseph Solerno). To artificially suppress gold as a barometer of inflation in order to encourage foreigners to continue accepting dollars as a global reserve currency, Johnson sold off America's gold reserves through the London market.
America lost so much gold during Johnson's gold suppression scheme that later in 1971 Nixon decided to close the gold redemption window for foreigners at $35 an ounce rather than devalue the dollar or rein in imports. Within a decade after the Federal Government took the lid off, gold soared to a high of around $850 in 1980 at the height of double-digit inflation.
Fraud note: James Turk reports strong circumstantial evidence that Lyndon Johnson may have foolishly disgorged vastly more of America's official gold reserves than has been officially disclosed. If true, this would suggest an interesting "the best defense is a good offense" strategy to get other central banks to disgorge their gold in the 1990's as part of a possible "national security" bureaucratic rationalization to cover up spendthrift recklessness and arrogant unaccountability. Former Swiss Rothschild banker Ferdinand Lips wrote in 2001 in his excellent book Gold Wars: The Battle Against Sound Money as Seen From a Swiss Perspective (footnote 75 to Chapter VII "Betrayal of Switzerland") that, "Recently, there has been growing doubt whether the U.S. is still in possession of its 261.5 million ounces it declared to be held in trust in the Department of the Treasury. Firstly, there has never been an independent audit of the U.S. gold reserve since 1955. Secondly, in September 2000 a strange reclassification was made in the Treasury Report. Over 54 million ounces of gold were switched from the category of `Gold Bullion Reserve' to `Custodial Gold Bullion' without as much as an explanation. Even more mysterious is the May 2001 Treasury Report where `Reserve' and `Custodial' gold have been entirely eliminated and are now labeled as `Deep Storage Gold.' Thus far, the Secretary of the Treasury, Mr. Paul H. O'Neill, has not responded to any questions put to him about the matter by politicians and citizens." According to William Greider in his classic work Secrets of the Temple: How the Federal Reserve Runs the Country, the Fed has never been subjected to external audit either. Some Treasury watchers think "deep storage" means the US no longer owns this gold. In the case of gold stored at West Point and other sites, it may now belong to foreigners due to gold swap deals. In footnote 20 to Chapter VII, Mr. Lips writes in regard to the decision by Swiss bankers to dramatically reduce their gold reserves in the late 1990's: "At the time, I was still naïve enough to believe that the Swiss central bankers were motivated by a patriotic interest in the value of the nation's money. I was wrong. All they wanted was to debase the currency. Throughout the world, central banks are engines of inflation, and they have very little interest in sound money. In fact, and especially in the U.S., the central bank is the creature of the banks. They conceived it, they lobbied for it and, de facto, control it. The purpose of the central bank is not to protect the currency, but to protect the banking system."
According to Gold Anti-Trust Action Committee (GATA), in the 1990's central banks sold or loaned out over half their reserves to fill the supply deficit in gold that has existed since 1987. The deficit became 1,000 tonnes a year by 1996, and according to GATA head Bill Murphy, now stands at around 1,400 tonnes. In the introduction to his 1998 Gold Book, Frank Veneroso commented: "Statements by Eddy George, Governor of the Bank of England, and Dale Henderson, staff director of the U.S. Fed have disparaged gold as a reserve asset. The prospect of a never-ending crushing supply of official gold now terrifies all the bullish advocates of gold and makes the bears supremely confident."
An important part of the intellectual cover for the gold sales was the trend by various European countries to form a European Central Bank by 1998 and merge their currencies into the euro. Obviously if the German Mark, French Franc, Dutch Guilder, and other expressions of nationalism were things of the past, then various European central banks required less gold to help defend domestic finances.
Ferdinand Lips describes in his book Gold Wars how various international organizations used a variety of measures to help knock the Swiss off their former Constitutional gold standard and encourage them to sell their gold reserves in the late 1990's. The measures included propaganda that gold is obsolete, veiled threats against Swiss overseas banking interests, initiatives to feed the world's hungry with gold sales, and complaints over fifty years after the end of World War II that the Swiss harbored "Nazi gold." Mr. Lips feels that the latter charges were unjust, and claims that during the 1950's the Swiss bent over backwards to identify, compensate, and otherwise help Holocaust victims.
Bill Murphy of GATA claimed in a May 31, 2003 interview with James Puplava that he thinks the Fed has even arranged payments to foreign central banks at prices for gold that are way above current market prices in order to get them to disgorge more gold into the market at below market prices to help keep the price of gold suppressed.
FUN AND GAMES IN THE COMMODITIES MARKETS
Bill Murphy, Ted Butler, David Morgan, James Puplava, and many other experts who closely follow futures exchanges have frequently commented on supply deficits and overhangs of short positions and derivatives contracts for both gold and silver. Currently total short silver positions that have helped to suppress rising silver prices have grown to 534 million ounces, a decade-long high, or roughly equal to the annual mining supply. Although paper long positions are equal to this, David Morgan claimed on the March 13, 2004 Financial Sense Newshour only about 10% of this sum consists of "registered" physical silver in warehouses available for guaranteed immediate delivery. Another 13% is "eligible" but requires more paperwork for actual delivery. A market that becomes this thin on physical delivery becomes particularly vulnerable when parties such as the Hunt Brothers in the 1970's or Warren Buffett in 1997 demand substantial physical delivery, which can cause silver prices to skyrocket. Morgan stated in his March 20th FSN update he can see a possible eventual silver price well above $150 an ounce. He cited such factors as severely dwindled above ground silver inventories after a 15 year supply deficit, rising demand for physical delivery, and an eventual reversion of the price ratio of gold to silver to somewhere near its 1:15 incidence in nature. (On March 21, 2004, with $412.12 gold and $7.53 silver, the ratio was 55)
Gold and Silver Production Deficits and Cumulative Supply Deficits.
[Source: Sharelynx; cf. James Puplava & EricKing's "BelieveIt!"]
Most futures contracts roll over rather than settle for delivery, allowing interventionists to paper over demand and drive down prices so long as physical supply and demand for physical delivery do not get too far out of alignment. In Gold Wars (Part IV, p. 81), Ferdinand Lips wrote: "As far as the gold market is concerned, it is estimated that the `paper gold' market in 1999 is many times larger than the actual physical market. Estimates range from a minimum of 90 to an excess of 100 paper-ounce contracts being written for every ounce of physical gold that changes hands. This is not only mind-boggling, or a Frankenstein monster as James Dines calls it, but a king-size horror trip."
According to GATA, the Fed has the ability to indirectly manipulate both the stock and commodities markets by feeding Wall Street firms money through the repurchase agreement pool. This is about $40 billion in size. The Fed and US Treasury can add another $30 to $40 billion from the Exchange Stabilization Fund totaling $80 billion. Major Wall Street firms can borrow billions of dollars for up to 28 days. The Fed can keep rolling all of this over, as if making a permanent loan. Wall Street firms are free to use this money any way they please, to include using futures contracts at strategic moments to move markets. They can make really big money by following the Fed's "body language." Last, but not least, they are highly motivated to remain loyal and sensitive as Fed "team players" in case they some day need an LTCM-style bail-out.
FROM GOLD PRICE SUPPRESSION TO REAR GUARD ACTION
The artificially strong US dollar policy could not go on forever. The dollar has been in decline for the last two years. The initial phase of the US bear market in stocks that ran from March 2000 to March 2003 began to shatter the confidence of foreign investors, whose earlier capital inflows played an important role in maintaining the strong dollar.
Low bond interest rates created by the Fed to prop up the asset bubbles are discouraging additional short-selling in gold. Speculators used to pay .5 to 1% to borrow and then sell gold from central banks, and then invest the proceeds in bonds. Bond rates are now so low that there is no longer a profitable spread. Furthermore, the trend of rising gold prices has made short selling more dangerous. This trend also discourages gold producers from hedging. If anything, the recent trend among producers has been to unwind their hedges.
Even if gold leasing remained profitable for short-sellers, central banks cannot keep selling forever to fill the current approximate 1,400 tonne per year supply deficit. According to Bill Murphy, they may be down to only 10,000 or 15,000 tonnes in reserves. At some point central banks will run out of gold, and world gold prices will skyrocket, making the central banks look even more foolish than they already appear for having disgorged gold well below current market prices in the late 1990's. In addition, one might ask what might happen if they get rid of all of their gold, and the world goes back to a gold standard?
Despite Barrick's aforementioned alleged sweetheart deal that allows it to continually roll over its short positions, we can not necessarily assume that all the gold that has been leased out by central banks will be contractually converted into gold sales at lower prices as gold prices continue to move up, or that derivative insurance against rising gold prices will be adequate in turbulent markets. According to John Embry of Sprott Asset Management, "Strong evidence suggests that between 10,000 and 16,000 tonnes (30-50% of all Central Bank gold) is currently in the market. This is owed to the Central Banks by the bullion banks, which are the counter party in the transactions." Even a very small fraction of short covering in this area could be explosive.
Politically, the European economic integration trend behind the creation of the euro that helped justify gold selling is unraveling. Many countries have balked at taking the last steps towards full integration, and many members of the EU are becoming increasingly restive over their inability to follow independent economic policies. As Mises Institute senior fellow Dr. Hans-Hermann Hoppe points out, the EU has often simply added increasing layers of regulation rather than helped to simplify and standardize regulations throughout Europe. Friction created by Third World immigration and other issues that fuel nationalism could motivate EU members to recreate their own currencies and other tools of national sovereignty.
Rising global gold demand is also putting gold suppression on the defensive. Russia has been accumulating gold, and according to John Embry there are rumors that far eastern central banks are quietly buying gold as well. Countries with large US dollar trade surpluses can do better buying gold (short of running up the gold price) than buying US bonds. US debt instruments can lose market value two ways for foreigners if the dollar continues to decline and if interest rates start moving back up. Both trends are highly likely.
Last, but not least, the strong bull market in commodities fed by Asian demand over the last two years appears to be pulling gold and silver along with it. On his web site Le Metropole Cafe and in his 6 March 2004 interview with James Puplava, Bill Murphy of the Gold Anti Trust Action Committee has been banging the table for silver, claiming that physical above ground inventories of silver are very nearly exhausted. He claims that there is evidence that China has contracted for 75% of annual silver production in 2005. Explosive upward movements in silver could help fuel speculative demand for gold.
DETERMINING THE INCREASE FACTOR FOR THIS SECTION:
If we apply a 5% a year or 28% total increase factor to $400 gold, that brings us to $512 an ounce for gold at the end of five years. This returns us to the technical support base shown in the Gold Newsletter chart for 1993-1995. Frankly I think it is highly likely that we will see $512 gold within one to two years, not to mention five years, but I am trying to be conservative here. The Gold Newsletter price scale is probably conservative to the extent that it uses understated official CPI numbers.
IMPACT OF CONTINUED DOLLAR SLIDE
AND GLOBAL INFLATION
Estimated increase factor: 5% a year or 28% cumulative total in five years
The U.S. is still running balance of trade deficits of around 5% of GDP. This has historically marked the danger zone for a currency crisis. Chinese and Japanese central bankers could easily sink the dollar overnight by simply conducting "business as usual" in global currency markets, that is, by simply selling off their huge trade surplus holdings. Instead, the dollar has made a gradual decline over the last two years only because of their active intervention. This is putting an increasing strain on their economies while rapidly growing trade within the Australia-Asia area provides an increasingly attractive alternative. As an example, Japan spent the equivalent of $180 billion buying depreciating dollars to protect companies against a rising yen in 2003. This was twice Japan's trade merchandise surplus and about 50% more than what Japan has received for its exports to the U.S. in each of last two years. In mid-March of this year Japan signaled that it might dramatically reduce support for the dollar.
As I discuss in Part II, the rise in the price of gold in dollars against the dollar decline over the last two years has actually been more of a dollar bear market than a gold bull market. But as China and various First World countries continue to inflate their currencies to help maintain export competitiveness to the U.S., this may create a global inflationary bull market for gold as well as undermine the ability of the US to correct its balance of trade problems. We could wind up with a global inflationary bull market for gold on top of a continuing dollar decline bull market for gold.
Professor Tim Congdon's 2002 World Gold Council research report describes how the US would need to convert 5% of GDP to exports just to stabilize its current account deficit growth with GDP growth. He cites several independent research reports that predicted a 25-50% dollar slide necessary to begin to find equilibrium. He presents formulas that describe how achieving equilibrium is positively correlated with GDP growth and negatively correlated with debt size and interest rates. Since we still have a 5% deficit despite the dollar decline in the last two years, the 25-50% decline projection may still be a valid forward-looking estimate.
In my Oct 29, 2003 article: "Templeton Trepidations, Buffet Battle Stations" I discuss why Warren Buffett divested his firm of $9 billion in US Treasuries and made massive purchases of foreign currencies, and why John Templeton has remained out of US bonds and invested in Canadian, New Zealand, and Australian bonds. Templeton believes the dollar is likely to slide further, although he is unwilling to quantify his views and comment on an Economist Magazine special report that expects a 50% dollar decline.
There are two major issues involved with a sharp decline in the dollar. One is that America has lost so much of its manufacturing base that it may take much longer than in the past for it to overcome its structural problems and benefit from cheaper export prices. An even more serious concern is the possibility that a rapidly declining dollar could lead to many out of control vicious circles.
A rapidly declining dollar might scare foreigners, who may in turn accelerate their disinvestment in American bonds and stocks, accelerating a dollar decline even further. To lure foreign investors back, who buy about half of the Federal debt, the Fed will be forced to raise interest rates. This can cause the stock market to decline further, scaring away even more foreign investors, and putting even more downward pressure on the dollar. In essence, America could experience a crisis involving a plummeting currency, skyrocketing interest rates, and crashing securities markets. This sort of macroeconomic behavior has been an all too familiar pattern with many spendthrift Latin American countries in the past few decades.
To add insult to injury, any sharp dislocations of the currency markets or other markets might trigger another crisis similar to the Long Term Capital Management (LTCM) meltdown in 1998. Robert Moriarity of 321gold.com commented in his March 13th Korelin interview that global debt now stands at $100 trillion, more than twice the world economy of $45 trillion. Even worse, the Bank of International Settlements (BIS) reports total derivatives at $207 trillion, or a little under five times the global economy. They have grown from zero in 1971 when Nixon completely de linked the dollar from gold. Derivatives help institutions hedge currency risk (previously dealt with through the simple use of gold) and also allow them to pawn off risk, leverage speculative positions, and avoid regulatory obstacles in building loan volume. Adding further to instability, we now have record bankruptcies in America in a supposedly benign environment with record low interest rates. Moriarity observed that since Bush was elected, America has lost three million jobs, and the countervailing gain of 750,000 jobs has been almost entirely in the public sector. If interest rates start moving up, and if we also see increasing instability between markets, this could help trigger a broad economic crisis and a derivatives meltdown far too big for the Fed or any other central bank to contain.
DETERMINING THE INCREASE FACTOR FOR THIS SECTION:
In choosing a dollar decline factor, I have selected the low end of Dr. Congdon's research and am using a factor of 5% a year or 1.28% total over five years. In this case it may be more reasonable to be conservative, since there may be overlapping, interactive effects with the 28% factor that I use for M3 growth that I describe next.
IMPACT OF CONTINUING M3 GROWTH
AND ACCELERATING PRICE INFLATION
Estimated increase factor: 5% a year or 28% cumulative total in five years
Charts that tell a big part of the story. [source: GrandfatherEconomic Report].
In the long run price inflation is a function of money supply growth in excess of productivity growth. The Fed has been increasing the money supply 8-10% a year over the last five years. This is about the same rate as during the Lyndon Johnson and Richard Nixon eras which directly preceded the double-digit price inflation of the late 1970's. Real productivity growth has been in decline over the last few decades and now stands around the .75% to 1.5% area. America now requires five dollars of increased debt to grow a dollar of GDP, and savings (the traditional basis of capital formation) is at record lows.
Aggressive price inflation is already here. Congressman Ron Paul noted in a recent press release that broad indexes show commodities have risen 49% since last spring, and that government CPI figures under-report inflation by focusing on rent figures softened by displaced demand for housing stimulated by artificially low interest rates while ignoring rising housing prices. Al Korelin noted in his March 6, 2004 Korelin Economics Report interview with Bill Murphy that so far in this commodities bull market steel is up 160%, aluminum up 50%, copper up 120%, and lumber is up 93%. Murphy noted that oil appears headed for $40 a barrel. He added that while the indices are screaming inflation every place, the administration comes out and says there is no inflation, and people accept it. "It is ludicrous, inflation is roaring, and Ron Paul is correct...In the CPI there are things they say they do not count such as food, energy, and then we have housing. So if you do not live any place, eat, or drive any where, then there is no inflation."
Aggressive money supply growth is a longstanding trend likely to continue. In his June 16, 2000 article "Lies, Damned Lies, and the CPI.," Adam Hamilton explains how M3 has grown at a 7.9% compounded rate since 1959 vs. 4.4% for the CPI. Fed Governor Ben S. Bernanke remarked in Nov 2002 that the Fed is prepared to inflate without limit if necessary.
Total Federal, state, and local government spending continues to grow four times as fast as the economy, especially now that the Federal government is running fiscal deficits that are approximately 5% of GDP to help fund its global war on terrorism. This absorbs additional global savings on top of America's other "twin" deficit –the balance of trade deficit.
We are also likely to see aggressive M3 growth to handle other rising costs. These other costs may include rising energy prices (discussed again in a later section) and increased costs related to protectionism.
Rising oil and gas prices are an increased cost on the American consumer. They typically reflect a combination of increased taxes to the government and increased transfers of wealth to foreigners, since a little over two thirds of our oil is imported.
We are likely to see rising protectionism as a political reaction to continued job loss to China and other Asian countries. America has lost half its manufacturing jobs in the last three decades. Unfortunately both the timing and the nature of the new "protectionism" will likely increase drag on the economy, putting more pressure on the Fed and US Government to create even more money to try to make up for shortfalls.
Fraud note: The "free trade" vs. "fair trade" national media debate regarding protectionism usually glosses over the most important issues, namely taxation and self-determination. Instead, the debate tends to pay homage to liberal internationalist ideology or pork politics. Protectionism means more tariffs, which at root are nothing more than sales taxes on foreign goods. All taxes are bad, to the extent that they wind up picking the pockets of the productive, real job-creating private sector and transferring wealth to the often wasteful, economically incompetent, and politically warped public sector. It is true that tariffs can be a least bad form of taxation and can comprise an important tool to steer business and reinvestment towards local industry while creating barriers towards countries considered too alien, duplicitous, or otherwise threatening for full social and economic integration. But despite all of this, tariffs remain costly. The Federal Government may wind up raising overall costs to society for the wrong reasons while it is already over-indebted and financially stressed.
In terms of raising revenues, the government has little room left to raise taxes to fund its runaway spending and massive debt obligations without throttling the taxpayer goose that provides the tax eggs. Total federal and state taxes on the average American are about 50% of income.
Cutting government expenditures is getting politically tougher. About 60% of Federal spending involves non-discretionary transfer payments and social entitlements. Although the official national debt at around $7 trillion currently stands at around 70% of GDP, this does not take into account over $44 trillion in un funded current liabilities for Social Security and Medicare that will start becoming a cash drain on the system once the first wave of baby boomers begin to retire in a few years. Demagogic politicians are likely to try to raise taxes anyway, just as they did in the 1930's to "spread the wealth." They are likely to seriously undermine the capital formation process needed to create more jobs and wealth, just as they did during the Depression. And of course if they see that their policies are not working, their answer to everything is usually always to print more money.
The Fed is not only creating money out of thin air to support runaway government spending, but it is also fueling credit growth with historically low interest rates to try to prevent collapsing bubbles in the bond, stock, and housing markets. It uses open market operations to buy bonds to help keep interest rates artificially low, monetize debt, and inject more money into the system to help keep the asset bubbles inflated. All of this also causes consumer prices to continually rise.
FOREIGNERS ARE ALREADY BEGINNING TO BAIL
Foreigners are beginning to ditch dollar reserves. Washing dollars back at the US can only add to price inflation. Half of the $18 trillion in global US dollars are held outside the US . About 68% of global central bank reserves consist of dollars. According to a Lehman Brothers analysis, in the last half of 2003 as much as $133 billion of foreign exchange reserves in non-Japan Asia out of $2 trillion total left the dollar for stronger, higher-yielding currencies such as the euro, pound, and Australian dollar. Asian banks financed half the current account and fiscal debt last year.
Vladimir Putin met with German Chancellor Gerhard Schroeder in Oct 2003 to discuss switching oil sales from dollars to euros. James Turk claims that OPEC countries are already tacitly pricing in euros. Many Islamic countries have threatened to convert to a gold-based Dinar in protest against America's interventionist policies in the Middle East and also as a defense against the declining value of dollar reserves.
The next shoe to drop will probably take place when foreigners cut back their purchases of America's fiscal debt issues and stop supporting its current account deficit. At that point the Fed will need to start raising interest rates to help lure foreign investment back. It will also need to print even more money to handle rising interests costs on the national debt. In addition, it will need to monetize portions of its own debt that foreigners and other investors are no longer willing to purchase. The Fed will likely repeat the same pattern of behavior that it showed in the stagflationary 1970's, in which it was slow to hike interest rates to head off inflation that got into the double digits. This created a real negative interest rate environment that lasted nearly a decade.
As discussed in Part II to this series, gold tends to perform particularly well in a negative interest rate environment. We are likely to experience double-digit inflation, if not hyperinflation, within this kind of environment some time over the next five years.
DETERMINING THE INCREASE FACTOR FOR THIS SECTION:
I think that it is likely the Fed will continue to grow the money supply by at least 10% a year for the next five years. 10% compounded over five years gives us an increase factor of 61%. To be conservative, I have used under half that number, or 28%, suggesting a 5% average annual compounding rate. This is lower than the historic M3 growth rate of 7.9% identified by Adam Hamilton since 1959. However, in the long run M3 growth and the dollar decline factor discussed in the prior section have a high correlation, so a lower multiplier factor intuitively helps to adjust for the overlap between these two variables.
IMPACT OF DECLINING MINING PRODUCTION
Estimated increase factor: 2% a year or a 10% cumulative total in five years
Newmont President Pierre Lassonde commented in his July 7, 2002 interview with Tim Wood of Mineweb.com that, "...Further, gold production is expected to decline by about 2-4% a year through 2010. Most 'marginal' projects have already been factored into the supply and demand balance. In addition, with exploration expenditure levels at record lows during the last five years, there are very few projects of any size that are 'sitting on the shelf' waiting to be developed. What we are seeing now is the logical result of the exploration budget cuts over the last five years - a dearth of new projects awaiting development."
John Embry, President and Portfolio Manager of the top-performing Canadian Sprott Gold and Precious Minerals Fund, stated in the Sept 20, 2003 update of his Fundamental Reasons to Own Gold, "...Mine supply will contract in the next several years, irrespective of gold prices, due to a dearth of exploration in the post Bre-X era, a shift away from the high grading which was necessary for survival in the sub economic gold price environment of the past five years and the natural exhaustion of existing mines."
Lastly, a Nov 2002 Worth Magazine article reported that the World Gold Council estimates mine supply is likely to decline 3 to 5% over the next few years, and noted that the average mine has a life of 10 to 15 years. Government permitting, community negotiation, feasibility studies, engineering reports, and environmental procedures often stretch out mining projects as long as 5-7 years from discovery until production.
DETERMINING THE INCREASE FACTOR FOR THIS SECTION:
If we factor in the impact of the lack of new exploration over the last five years, as well as the impact of delays in permitting over the next five years, and add on to this the impact of a substantial decline in mining production due to normal mining life span expirations over the next five to ten years, it seems conservative to use a 2% annual gold price appreciation factor for a cumulative five year total of 10%.
Click HERE to continue to Part B of this essay.