Gold and the broadening specter of competitive currency devaluations

By Dr. Richard S. Appel         July 23, 2003 www.financialinsights.org

Throughout modern history, periods of worldwide economic decline have been accompanied by spates of competitive currency devaluations. These have repeatedly occurred during difficult times as country after country, in their effort to gain an advantage over their trading partners, fostered a weakening of their currencies. The hope of each domain has always been that a weaker domestic currency would stimulate world demand for their goods and services. This, they believed, would foster an increase in their output and generate a renewed round of economic expansion. It always began with one nation’s attempt to benefit itself, but ultimately spiraled out of control when others followed their lead.
In practice, using currency devaluations to enhance one’s domestic economy has never worked for long. The reason is simple. It is one of human nature. What was consistently overlooked was that other governments would not stand by idly. They would not allow a competing country the ability to gain an upper hand and a trade advantage over them. To the detriment of all, the end result of each such experiment has produced animosity between the engaged nations, a worsening of their economic declines, and it has even led to war. It is a glaring frailty of mankind that neither individuals nor politicians rarely seem to learn from the experiences of their predecessors.

I have discussed the threat of the impending onset of competitive currency devaluations for quite some time. However, before I continue I believe that I should relate some history to help better understand the distinction between an official devaluation of the past, and what we should expect during the present time. Under the gold standard, gold was utilized to give value to all of the world’s major currencies. It was the sole or primary item used to guarantee the worth of a paper currency. During that era a devaluation occurred when a nation officially reduced the value of their money against gold. Also, the money supply of a nation was dictated by their gold holdings and fixed or relatively fixed exchange rates existed between currencies. Further, the money supply of a nation rose and fell depending upon its gold holdings, and the size of its monetary aggregates was affected by their balance of trade surpluses or deficits. If they overspent and purchased a greater amount of goods and services from another nation, the deficit was paid for with gold. Further, when the overspending land lost gold reserves they were forced to accordingly reduce their money supply. In 1971, the official price of gold was 35 U.S. dollars an ounce. In August of that year President Nixon reduced its value by announcing the de jure devaluation of the dollar to $42.22 U.S. dollars to one ounce of gold.. Thus the dollar overnight, officially lost over 20% of its value. The dollar had already been sinking in parity against the other major currencies, but this decree was the official announcement of the dollar’s instantaneous reduction in worth.

Today, since the world exists solely on a U.S. dollar standard with floating exchange rates, the term devaluation is not accurate. What we now have is an environment where all currencies freely float against one another with their relative values being dictated by the marketplace. Thus, one currency either loses or gains value against that of another country. This allows any nation to expand their money supply at will, and to any level that it desires. The discipline of gold has been replaced by the whim of politicians

Competitive devaluations are actually a form of unspoken trade warfare. As the effort to undercut the prices of those things offered by other nations intensifies, through repeated contrived currency declines, each government begins to devise schemes to benefit their own territory. Tariffs, duties and other barriers to free trade begin to be erected. These prohibit or raise the prices of goods entering the various countries. Later, other societies are drawn into the battle for exports. They erect their own levies against the entrance of products emanating from other domains. The end result may be a virtual halt of inter-country trade. When it reaches this stage everyone suffers.

Free trade gives every nation the ability to sell to the world community those products that they can best produce in the most cost effective fashion. This allows each country to devote its efforts to supplying those things in which they excel. If every nation follows this path all will benefit. It offers the citizens of one land the opportunity to pick the best available products from the world’s producers, regardless of their origin. This empowers the world’s consumers with the capacity to get the most for their money and thereby increases their standard of living. Conversely, if barriers to trade are erected, the citizens of one country must increasingly rely upon those goods and services manufactured within their own borders. Many of these are generally more costly and may be inferior to those that they could otherwise acquire. The result is a reduction of available choices, a decline in the standard of living, a further depressed state of economic activity, and the rise of inflation.

If one nation was able to unilaterally reduce their currency’s parity with those of their trading partners, the devaluating country would certainly benefit. This would result from the unique position which their cheapened currency would foster, where their goods and services would become the most desirable. Money would flow into their country as other lands would seek to take advantage of their now less costly products. However, we do not live in a world where one nation will ever be allowed to benefit from depreciating their currency to the detriment of their fellow trading partners. This is where the problem arises.

When the first government allows or encourages the decline in its monetary unit’s value it will not go unnoticed to the world community. Japan, various other Asian countries and the U.S. have already embarked upon this path. China, by pegging their yuan to the U.S. dollar, has covertly fostering the depreciation of their currency. Now, these conditions have attracted the attention of what appears to be the newest entrant into the melee; the European Community. Last week, German Chancellor Gerhard Schroeder called for the central bank of the EC

to intervene in the markets to weaken the euro. It remains to be seen if his suggestion will be followed. Yet, history tells us that his desire will likely come to fruition. In time, still other nations will be drawn into the fray. They will become frightened that their economies will suffer if they do not follow the lead of the other lands and also depreciate their currencies. Eventually, as currency values spiral downward, the initial instigating countries will additionally weaken their paper currencies in order to maintain their competitive advantages.

After resorting to monetary stimulus several years ago, in their effort to stem their long-term economic contraction, the Japanese government has recently further increased their rate of monetary creation. Their interest rates are already near zero so they have lost the ability to use this aspect of monetary policy to reduce the yen’s desirability. The U.S. began to aggressively expand the size of our monetary aggregates in December, 1993. The degree of expansion was further raised over a year ago. Today, it now appears that all stops are being pulled in the Federal Reserve’s frantic attempt to reflate the economy. The past four weeks have witnessed a huge rise in M3. If it continues it will be unprecedented since the 1914 inception of the Federal Reserve System. Following seasonally adjusted increases of over $20 billion in each of the first two periods, the last two weeks have experienced M3 rises of over $61 billion and nearly $50 billion respectively. This represents $150+ billion, or a 1.8% increase in just the last four reporting weeks. This works out to a mind-blowing year over year rise of 22%! I do not remember a similar explosive performance in M3. Even the periods leading up to the potential Y2K problem, and when our nation’s financial system was threatened by the liquidation of Long Term Capital Management, do not compare in magnitude.

Today, the primary threat that our nation is facing is that of a possible deflationary spiral. It is likely that the incomprehensible jump in M3 is the Fed’s attempt to avert such a catastrophe. I do believe that the odds favor their success. However, the amount of inflationary purchasing media that they may be forced to create is likely to later haunt us. This, when they then turn from averting deflation to fighting the inflationary dilemma that they may now be creating.

All of the above are leading to an explosive condition for gold and gold stocks. Eventually, the world’s citizens will awaken to what has transpired. As one country after another aggressively fosters an increase in their money supplies, in their efforts to make their currencies more competitive, a major juncture will be reached. When that occurs, the world will realize that all of the major paper currencies will have lost much of their value, and will have become far overvalued relative to gold. That awakening will spur them to seek the primary haven in which to protect their remaining assets. They will lust for the only real money; gold. This transition will not occur overnight. It will likely require several years before the gradual effects of competitive currency depreciation, and the barriers to free trade are erected, creates much pain. When that time arrives the world will understand the reason why the poorest French peasant for generations hid pieces of gold under his mattress. Learn from them. Gold will act as your life-raft in preserving your assets, as it did for them.

The above was excerpted from the August 2003 issue of Financial Insights © July 20, 2003.

I publish Financial Insights. It is a monthly newsletter in which I discuss gold, the financial markets, as well as various junior resource stocks that I believe offer great price appreciation potential.

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Disclaimer: FINANCIAL INSIGHTS is written and published by Dr. Richard Appel and is made available for informational purposes only. Dr. Appel pledges to disclose if he directly or indirectly has a position in any of the securities mentioned. He will make every effort to obtain information from sources believed to be reliable, but its accuracy and completeness cannot be guaranteed. Dr. Appel encourages your letters, but cannot respond personally. Be assured that all letters will be read and considered for response in future letters. It is in your best interest to contact any company in which you consider investing, regarding their financial statements and corporate information. Further, you should thoroughly research and consult with a professional investment advisor before making any equity investments. Use of any information contained herein is at the risk of the reader without responsibility on our part. Past performance does not guarantee future results. © 2003 by Dr. Richard S. Appel. All rights are reserved. Parts of this newsletter may be reproduced in context, for inclusion in other publications if the publisher's name and address are also included for credit.