INCREASING ASIAN AND OTHER GENERAL INVESTMENT
DEMAND FOR GOLD AND COMMODITIES
Estimated increase factor: 3% a year or a 16% cumulative total in five years
As previously mentioned, the Commodities Research Bureau (CRB) index, composed of 17 different commodities, is up over 42 % since Oct 2001. Gold and silver tend to participate with broad moves in commodities, as they did in the stagflationary 1970's. Recently the charts show commodities and gold moving together.
Growing demand for industrial goods by China, India, and other Asian countries has been putting upward pressure on a wide variety of commodities, to include copper, zinc, and iron. China claims its growth rate reached 9% in 2003, and its raw material demand is tying up 25% of global bulk shipping capacity.
In regard to investment capital, excess liquidity from the Fed and other central bank stimulus is flowing out of paper assets and into commodities, particularly in a negative interest rate environment. On top of this, China has opened a National Gold Exchange. Gold demand in China among its 1.2 billion people could reach 500 tonnes in the next few years.
Global investment demand may be enhanced in the years ahead on an individual investor level by the creation of easier ways to buy and sell gold through such means as stock exchanges and online accounts. In addition, rising gold prices can help to stimulate new demand from momentum investors and investors who feel that rising prices enhance gold's aura as an investment vehicle and as a natural form of money.
More high-level policy makers are talking about remonetizing gold. According to John Embry,"Islamic nations are investigating a currency backed by gold (the Gold Dinar), the new President of Argentina proposed, during his campaign, a gold-backed peso as an antidote for the financial catastrophe which his country experienced and Russia is talking about a fully convertible currency with gold backing."
Rising energy prices have a double impact. They help boost commodity price indices, which can help drag gold and silver along. As mentioned earlier, they also increase costs to Americans, and put pressure on the Fed to monetize debt to handle Federal tax revenue shortfalls as taxpayers get squeezed. There is a chance that oil prices could climb as high as $50 a barrel within a year or two. Chinese and Indian demand remains in a steady up trend. Meanwhile on the supply side, Saudi Arabia, which has been the world's largest producer, is beginning to show signs of maturing production, to include increased water shows in its wells. OPEC members inflated their reserve numbers in the 1980's in an effort to increase their export quotas and may be at peak capacity and facing decline curves sooner than expected. America passed the point where it can find new reserves to replace current production in the 1970's. The U.S. now imports around two thirds of its oil. Technical data collected by industry veteran Jean Laherrère suggests that proven and probable world oil reserves are on a decline curve.
DETERMINING THE INCREASE FACTOR FOR THIS SECTION:
Investment guru Doug Casey thinks that the trend of steady growth in Chinese demand could see some near term retrenchment. China claims it has a Non Performing Loan (NPL) problem in its banking sector. In contrast, goldinsider.com editor John Lee disagrees. Over the long run both remain very bullish on China. A factor of 15%, reflecting a little under 3% growth a year, seems conservative, all considering. This may be especially true if we factor in possible rising demand from momentum investors if gold maintains its upward trend.
IMPACT OF INCREASING CRISIS INSTABILITY
Estimated increase factor: 2% a year or 10% cumulative total in five years
This is the most difficult factor to assess, since it is based on a subjective assessment of the likelihood that any of a growing variety of "accidents-waiting-to-happen" will in fact take place.
SOME POTENTIAL POWDER KEGS
Both gold bullion and gold stocks comprise relatively thinly traded markets that could skyrocket with sudden massive investment demand. The total world gold supply is 4.75 billion ounces. At $400 an ounce, is worth $1.9 trillion. This is only 20% of America's GDP, and worth only 10.5% of the estimated $18 trillion dollars in existence at home and abroad. The total market capitalization of all the gold mining companies in the world combined is somewhere close to $100 billion. This is less than half of the current market cap of Microsoft.
The derivatives market has swollen to an estimated $207 trillion and is vulnerable to system failure. Nothing has changed since the Long Term Capital Management melt-down in 1998, except that the total quantity of unregulated derivatives has multiplied. Warren Buffett has called derivatives "Weapons of Mass Financial Destruction." The ability of major investment firms to clear their derivatives positions could be imperiled by a crisis that changes the liquidity characteristics of financial markets. In addition, major financial institutions are more leveraged today than ever before. If a major institution such as JP Morgan Chase goes under, the Fed may have to hyper inflate to provide a back up.
America has increased its open-ended military commitment that could lead to new quantum increases in expenditures. The U.S. Government has already experienced a quantum increase in expenditures since 9/11 that rule out a balanced budget and show no light at the end of the tunnel. Anti-American forces in the Middle East may become more effective in inflicting escalating costs. Any of a number of incidents, such as the possibility that Pakistan (which has nukes) or Saudi Arabia (which has the largest oil reserves) could fall into unacceptably hostile hands might cause further military interventions. Throughout history, war has often lead to unintended consequences and unexpectedly long campaigns that have in turn led to ruinous hyperinflation.
Foreign creditors can force a major crisis simply by pulling the plug. As discussed previously, the US trade deficit at 5% of GDP has reached the point that normally triggers a currency crisis. Foreigners can increasingly deliver shocks to America through passive resistance rather than active measures, to include repudiating the dollar as a reserve asset. Unfortunately current trends may create vicious circles in this area. In his Dec 8, 2003 editorial "Paper Chase," James Sinclair noted that the Patriot II Act, which does not require due process for the US to seize foreign assets, is already inducing foreigners to start pulling their money out of the US. As America loses more jobs overseas, this increases pressure on politicians to promote forms of protectionism that could risk provoking devastating forms of trade or investment retaliation. A financial crisis could easily force the Fed to hyper inflate.
Failure to turn around deteriorating macroeconomic trends. Time has become America's enemy rather than its friend so long as America continues to show that it is incapable of turning around serious deteriorative trends. Its real un funded liabilities (to include Social Security and Medicare) are over five times GDP, well over the 120% of GDP threshold often seen as a liquidity trap tripwire. Rising interest rates could trigger a compounding effect that could make total bankruptcy inevitable.
DETERMINING THE INCREASE FACTOR FOR THIS SECTION:
The 2% a year or 10% cumulative five year value I assigned is meant to be a minimal "marker" value to give this factor some visibility. Over the next five years the impact of this factor could range from zero to a figure well over 200%. No one knows. However, even if none of the aforementioned accidents waiting to happen take place, growing levels of vulnerability and instability could nevertheless increase investor anxiety, which in turn could increase the value of gold as an alternative investment vehicle.
Self-sufficient attitudes in 1836. Volunteers from Tennessee, South Carolina, Mississippi and elsewhere in America help Texans achieve greater local autonomy without Federal government or central bank intervention.
LOOKING OUT BEYOND FIVE YEARS
WILL CERTAIN "ANACHRONISMS" RETURN TO THE FUTURE?
The biggest boost to gold prices might come about if gold were remonetized, that is, all or part of America were to return to a gold standard reminiscent of the 1800's. We have already seen some small but important steps in this direction with such examples as the development of online GoldMoney, or the recent introduction by New Hampshire State representative Henry McElroy of the Sound Money Bill (HB 1342) that would allow people to transact with the state government using US-minted gold and silver coin.
As I explain later in this series, the decline of gold and silver as money has had an interesting inverse correlation with the steady growth of Federal monopoly power since 1861. Perhaps we can call this period a 143+ year bull market in "government" (Federal and state). This federal and state government bull market has expanded its share of GDP from less than 5% in 1861 to over 42% today. In my opinion, much of this has to unravel on many different levels, to include various social, political, and ideological levels, in order to see a full remonetization of gold and silver.
If in fact government hits a financial wall and a huge unraveling process does take place, Americans may be forced on a local level to return to many of the self-sufficient, pro-hard money, and anti-centrist attitudes and values held by the pioneers who once created the Lone Star Republic in Texas, the Grizzly Bear Republic in California, and the provisional government of the Oregon Territory. Come to think of it, this may not be such a bad thing. Under the gold standard, the dollar appreciated 50% by 1900 compared to 1800, despite the inflationary Civil War, and America enjoyed noteworthy periods of economic growth, innovation, rising living standards, and declining interest rates.
It is interesting to try to compare data from the gold standard era to today. According to Franklin Sanders, in 1861 an ammunition plant supervisor in Memphis, TN made 11.3198 ounces of gold a year. At $400/oz gold, that is $4,527 a year today. In 1997, the average small arms ammunition plant production worker made $31,914 a year. Even if we assume living standards have gone up let's say about two and a half times, that still leaves gold room to triple from here, particularly if gold is remonetized.
It is also interesting to note how debauched the dollar has become since the creation of the Federal Reserve in 1913. According to Dr. Murray Rothbard's book America's Great Depression, (page 91), the total money supply in America on June 30, 1921 was $45.3 billion. This was roughly twice what it had been in 1913 as a result of World War I inflation. The expansion from a monetary base somewhere around $20-$30 billion dollars in 1913 to around $16 trillion global M3 dollars today might represent a staggering increase of perhaps as much as 400 times. In contrast, gold at $400 is up only 19.4 times from its $20.67 peg under the old gold standard. (I provide these numbers for rough comparison purposes, since "total money supply" for mostly domestic use in 1921 may have had a very different meaning than globalized "M3" today).
Imagine if we were to try to go back to a 40% reserve policy similar to the 1800's, and if we were to use a gold price of $400 to try to figure out how many ounces we need as reserves in America's vaults:
|40% * $18 trillion|
|-------------------||= 18 billion oz gold needed as reserves.|
We have a problem here. There are only 4.75 billion ounces in existence above ground on the planet. Obviously we would have to drop our reserve ratio and/or increase the price of gold dramatically.
Let's say we could get our hands on every ounce of gold on the planet. We would then need to raise the gold price 3.78 times to $1,516 an ounce to back up 40% of existing dollars.
Let's say the US Government decides to back up just 20% of its dollars with gold. Then, lets say that it gets its hands on 10% of the world's total 4.75 billion ounces of gold as a back up, even though America currently has an approximate 25% share of global GDP. Here is what the calculation would look like:
|20% * $18 trillion|
|----------------------------------------||= $7,579 an oz.|
|4.75 billion oz global gold * 10% for US res.|
This calculation is meant simply to aid the reader's intuition about how almost any feasible assumptions that we apply to a model regarding remonetization of gold is likely to see a whopping increase in the gold price.
There are obviously other complicating factors that could apply in the real world. As one example, if other countries around the world adopt a 100% gold standard, the world market price for gold could skyrocket above our theoretical reserve price and help dictate to America a price reflecting a 100% reserve ratio. On the other hand, all things being equal, we might be able to afford a lower reserve ratio for gold if we introduce other forms of commodity money such as silver that could compete with gold-related money.
In the early 1800's Americans used silver certificates and silver coin as much, if not more, than gold. In his series "What Has Government Done to our Money?" Dr. Murray Rothbard suggested pegging the dollar to gold, while simultaneously allowing silver and other forms of commodity money to "float" with the free market rather than get pegged in a specific exchange ratio to gold and the dollar.
How much reserve back up would we need?
There is no one right answer. As a historical reference point, while America was on a "gold-plated" standard in the 1800's, banks were required to back up 40% of their currency with gold. The same was true of most countries around the world during that era. Switzerland used a 40% reserve ratio until it dropped its gold standard in the late 1990's. As I describe in a later part of this series on the history of gold in America, within a decade after the Federal Reserve Banking system was created in America in 1913, the gold reserve ratios in banks across the country plummeted down to the single digit level. Faith in back-up by the "Fed" replaced faith in a gold "back up."
The equation above shows that the lower the reserve ratio we try to use, the lower the price of gold that we can set. However, the lower we try to set a reserve ratio, the more we increase the risk that any particular run on the financial system could quickly deplete all the gold reserves. So this is really a situation involving trade-offs between intangibles. On the one hand we balance "confidence" in the overall integrity of the banking, financial and economic system against the depth of our gold reserves to endure a run on our currency should people begin to lose confidence.
There is a paradox here similar to spending on national defense. Theoretically, the more a country invests in gold reserves and spends on national defense, the less likely it will be that it will ever need either for defensive purposes.
What percentage of the world gold supply would the U.S. need?
Let us first look at the current official U.S. gold reserve situation. According to the World Gold Council, the U.S. as of Dec 2003 had 8,135 tonnes of official reserves. This comprised 58.22% of official world gold reserves and 5.5% of the 147,800 tonnes of above ground global gold existing (Goldfields, end of 2002). If we use 5% of world gold as a reserve for 20% of 18 trillion in global dollars, that means that we would need to set the gold price at $15,157 an ounce.
There are a number of factors that make a calculation of an appropriate percentage of total gold that would be necessary to back up the dollar really tricky. Intuitively it would seem that if the US has 25% of global GNP, it should obtain about 25% of the world's gold. However, 25% of world gold seems totally beyond the pale given circumstantial evidence described by James Turk that the US may not even have even a small fraction of the 5.5% of the world gold supply that it claims it has. Given the thinness of gold markets, if in fact the U.S. is out of gold, making purchases just to get back to 5% could be a nightmare.
The ultimate focus should be on restoring the free market and taking money out of the hands of government, not the particular dollar peg price for gold.
In Part VI titled "The Propaganda War Against Gold" I describe Dr. Murray Rothbard's argument that it does not matter what particular price is used as a peg for gold under a gold standard as long as it reflects an equilibrium free market price for gold and a reasonable relationship between the supply of gold held in reserve and the supply of dollars. Once the dollar gets fixed against gold, it becomes "as good as gold," and the system can function just as effectively if a dollar reflects .00025 ounces as if it were to reflect a different ratio that has more decimal places. The main concern is that the system is created with sound free market pricing relationships to begin with.
The biggest issue involves creating and maintaining a stable monetary system out of the hands of politicians. It also involves creating fairly constant monetary reference points that become the basis of a "galaxy of prices" that aid entrepreneurial calculation and help avoid economic imbalances. More on all this later in this series.
IS REMONETIZATION OF GOLD EVEN POSSIBLE IN OUR LIFETIME?
I agree with Texas Congressman Ron Paul that there is a strong likelihood that the United States Government will eventually hit a financial wall. Although this probably will not happen tomorrow morning, it is possible that it could happen as soon as within the next five to ten years. There are increasing numbers of wild cards in the hands of foreigners that make the near term odds almost unknowable.
I originally thought it would most likely happen at the end of the next likely credit bust cycle, say around the years 2030-2040, by extrapolating from the Dow/Gold ratio chart near the beginning of this article. Given current demographic trends, the 2030-2040 era might mark a tipping point where most Baby Boomers have died off and America becomes an extremely unstable hodgepodge of disparate, unassimilable, and majority "Third World" peoples, as envisioned in Peter Brimelow's classic work Alien Nation. However, the ability of Bush, Greenspan, Neo-Cons, & Associates to fast-forward the imperial overstretch, profligate spending, and alienation process has impressed me enough to revise forward my estimates.
To gain some insights into a "terminal drop" process that took a seemingly monolithic system by surprise, in the year 2003 Lew Rockwell, Director of the Mises Institute, invited former Soviet leader Mikhail Gorbachev as a speaker. (cf. Rockwell's talk "How States Fall and Liberty Triumphs"). Rockwell claims that Gorbachev really tried to save the old Soviet system. He tried to give the appearance of leading reform rather than reacting to it. As Rockwell puts it, before violent oppression by Gorbachev became a viable option to maintain the old system, he was "run over by history and out of a job."
In Part XI of this series I will try to examine various scenarios in which remonetization of gold and silver could take place alongside various possible restructurings of the social and political order in America in the event that such 20th century institutions as America's central bank and its ever-expanding fiat money and credit creation system get run over by history.
The remainder of this series is still undergoing completion.
Please stay tuned...
Click HERE to return to Part A