Kitco - Exclusive Commentaries

A baseline overview and a psychological, political, and historical approach
regarding the emerging gold bull market

In the long run, gold has been very effective for preserving purchasing power, and has won out over all efforts by governments to manipulate and suppress it. It is one of the oldest, most tried and proven forms of money,. It often serves as a long-term inflation barometer. However, in the short run, in addition to suffering as a victim of anti-gold campaigns sponsored by governments and central banks, gold may also be a laggard in keeping up with inflation and commodities. It may even do better in certain deflationary environments.

There are obviously some paradoxes involved here, since gold at some point has to play “catch up ball” with commodities and inflation if it is to preserve its purchasing power over the long run. It must also somehow outperform periods of inflation while also outperforming deflation. On top of all of this, gold must somehow remain an eternal form of money.

This series will try to explain these paradoxes and why gold may still be significantly undervalued despite its 68% run from its July 20, 1999 London PM fix low of $252.80 to its most recent high on Jan 13, 2004 at $425.50. I discuss why we may now be in the sweet spot of a continuing gold price appreciation cycle that could possibly last longer than five years and may carry gold well over $1,000 an ounce. This could be augmented by macroeconomic and political fault shifts that may become timely. I also explain political and philosophical reasons for why gold may be significantly undervalued today, and address the risk that the US Government’s confiscation of gold in 1933 may be repeated.

Gold prices are more ideologically and politically driven than virtually all other commodities, if not investment vehicles in general. Gold can serve as a social litmus test regarding respect for property rights and for governmental self-restraint and transparency. Particularly fascinating to me is strong historical evidence that when societies cut their “golden anchor” (go off a gold standard), this frequently coincides with cutting other important social, political, and ethical anchors as well. These societies tend to become more socially “leveraged” as well as more financially leveraged. The abandonment of gold correlates with increasing fraud, centrism, and intrigue, which in the initial phases tends to coincide with increasing marginalization and demonitization of the precious metals. At some point economic imbalances and various forms of social and political fraud reach a crisis tipping point, and then gold and silver tend to make huge moves as they play “catch up.”

I use the term “fraud” in this series in a very loose sense. “Fraud” suggests forms of continuous institutionalized or individualized deception resulting from active measures, sins of omission, or willful blindness in regard to determining and disclosing truth. Often deception and denial are performed on a subconscious level, hence my use of the psychoanalytic “Id” concept. It is not just “neurotic New Yorkers” who are involved here. We are all victims of self-deception to some degree or another.

Although I use the term “fraud” loosely, the reader still needs to be mindful of how even white lies can become destructive. The hard dark side of fraud can be criminal or war-like. The ancient Chinese martial philosopher Sun Tzu once noted that, “All war is based on deception.” A society that experiences growing internal fraud is likely a society that is increasingly at war with itself. It is increasingly filling itself up with all the toxins of rising “hate by other means.” Intuitively we can already begin to grasp how such a society is likely to become increasingly distorted economically and turn its attention away from things of real value. The poisoned tree starts producing stunted limbs and withered fruit.

Intuitively, the reader may also begin to grasp how in an ironic way, societies often get treated in the very long run the way they treat gold.

Gold has a dual nature, both as a commodity and as one of the oldest forms of money.

Gold is the most nonreactive, ductile, and malleable of all metals. It is one of the most reliable electrical conductors for extreme conditions and is also an excellent conductor of thermal energy. A single ounce can be drawn into a wire five miles long, and it can be hammered into a sheet so thin that light can pass through. In addition to jewelry, gold has industrial uses that include dental fillings, “fail safe” auto airbag electrical contacts, and components for cell phones and DVD’s. Gold is used in the manufacture of over 50 million personal computers a year.

An estimated 90% of all gold ever mined still exists in some above ground form. According to Gold Fields Mineral Services, at the end of 2002 this came to 147,800 tonnes (or about 4.75 billion ounces). Perhaps 23% is held by central banks, although the amount of gold they have loaned out since the early 1990’s and can feasibly retrieve is subject to debate. The remaining approximate 77% is privately held for jewelry, bullion, and coin. Average annual demand from 1997 to 2002 was 3,823 tonnes, of which 81% was for jewelry, 9% for retail investors, and 10% for industrial use. Since around 1987, demand has exceeded mine and scrap supply. In 2002 mining supply totaled 2,600 tonnes. The amount of scrap on top of this is difficult to determine but probably not significant. This suggests a supply deficit of roughly one thousand tonnes. (Note regarding measures: 1 tonne = 1 metric ton = 1,000 kg or 32,151 troy oz of gold, 12 troy oz = 1 troy pound, not 16)

One might expect that if demand has exceeded supply since 1987, that the price of gold would steadily increase. Up until early 2001, this has not been the case. In fact, adding to the mystery, gold began a decline from $414 in Feb 1996 down to the mid $250-$260 area in mid 1999 and early 2001, threatening to put half the world’s gold mines out of business. As noted by Sprott Asset Management, while officials have acknowledged cumulative gold short position at over 5,000 tonnes, realistically they may exceed 15,000 tonnes, which is roughly five times annual mine supply. A day of reckoning could eventually result in an explosive upside. In Part II of this series I discuss how an artificially strong dollar in the late 1990’s correlated with declining gold prices, and in Part X, I discuss the ongoing law suit by bullion dealer Blanchard & Co. charging conspiracy to artificially lower gold prices against Barrick, a major gold producer, and JP Morgan Chase, a major US bank.

Gold remains one of the most difficult and costly metals to find and extract. Compared to iron, which must be concentrated in geological anomalies five times more than it is randomly found in the earth’s crust to be economically mined, gold must be at least 1,000 times more concentrated than its random natural occurrence. Only about one in five thousand gold mining claims results in a profitable mine. Most rich surface anomalies quickly fade out rather than form economic trends. It takes typically five to seven years from the discovery of an economic anomaly to complete the permitting and feasibility study stages and get a mine into production. Gold costs an average of between $238 an ounce to $300 an ounce (1997 Fed Reserve Board estimate) to extract. The average wedding ring requires extraction and processing of ore in a volume amounting to about six feet by six feet by ten feet.

Despite its rarity, like other commodities, the price of gold responds to supply and demand changes. As an example, over a period of two centuries (16th and 17th), the steady accumulation of gold and silver brought to Europe from the New World by Spain doubled the supply of these precious metals, and dramatically reduced the price of gold and silver in many countries. Supply additions from the California gold rush of the 1840’s and also from South African finds and Klondike in late 1800’s also had an impact. However, since 1492 the annual global gold supply increase has never exceeded 5%, and in the last century it has never exceeded 2% a year.

The demand for gold within a country varies directly with both its degree of industrialization and its per capita wealth. Jewelry demand corresponds not only to wealth but also to cultural and other “mind share” factors. Asians have historically demanded more gold per unit of wealth per person than their Western counterparts.Despite America’s relatively lower “mind share,” the Mineral Information Institute and the Geological Society of America supply information suggesting that the average American consumes in his lifetime more than twice the estimated .75 oz of gold that exists per each of the 6.3 billion inhabitants of earth.

Gold increases dramatically in price as it becomes “monetized,” that is, the more people use it in the place of fiat currencies. Fiat money consists of paper currencies backed only by the taxing power of government. Based upon thousands of years of trial and error, civilizations have found gold to be the most highly desirable form of “commodity money.” Gold is highly portable, divisible, fungible, durable, and has a high ratio of value per unit of weight. These characteristics make gold highly suited to fulfill the three basic functions of money, namely as a medium of exchange, store of value, and unit of account.

Gold can significantly lose value when it is “demonetized” and shoved aside by fiat currencies, but still it tends to retain a certain minimal “mind share” relative to national wealth based on both its jewelry value and fear that some day the fiat currency will become totally debauched.
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Significantly, no major countries today are on the gold standard. For the first time in history, they all float on oceans of fiat currencies backed only by confidence in their respective governments that they will not completely debauch their currencies. It is very hard to think of any fiat currency in history that has survived for many generations without becoming totally debauched.

Under a gold standard, owning gold can act almost like owning a share in a country mutual fund that benefits from steady GDP growth. As an example, a person in Britain could buy nearly twice as much with an ounce of gold at the end of the gold standard period in 1914 as in 1821. During this entire period one ounce of gold remained fixed at 4.25 British pounds. Average consumer prices during this period declined by roughly one half as a result of the Industrial Revolution, prosperous overseas trade, access to raw materials, the absence of catastrophic wars, and other factors. Trains reduced the cost of overland transportation by over 90%, and steam and electrical engines dropped the cost of manufactured goods over 50%. During this period, additions to Britain’s gold-based money stock from mining supply grew at a much slower rate than the rate of productivity increases. As explained in Part VI of this series, a number sources such as the Mises Institute video on Money, Banking, and the Federal Reserve claim that business cycles were less severe and economic growth was more consistently strong for both Britain and America while both were on the gold standard than after they abandoned it.

Obviously there are a lot of relativistic variables that continuously impact on the value of gold as both a commodity and as a form of money. The platitude that gold will always be “the eternal constant,” or that in the long run “gold only stores but never gains value” are both too simplistic. Gold is very likely, but not guaranteed, to remain relatively more constant and limited in supply than most other commodities. Under certain conditions, it can steadily gain in value as well as preserve wealth. The value of gold can also decline dramatically due to such factors as demonetization, supply increases, or catastrophic reductions in per capita wealth. It remains highly unlikely in the foreseeable future that nuclear physicists will figure out how to economically move elements on the Periodic Chart into the “AU” square.

When the pros and cons of a gold standard are weighed against those of alternative monetary systems, I believe that gold remains the least bad long-term approach to money, particularly when managed by a least bad form of government.

One often hears that gold does better in deflation than inflation. This is a half-truth. By definition, under the gold standard that existed throughout most of the 1800’s, gold must do well in a price deflationary environment. After all, if prices are dropping, and gold remains pegged to the dollar, and one dollar remains one dollar, logically what else can happen? However, once gold was un-pegged to the dollar and became increasingly demonetized in the 20th century, its price behavior relative to inflation, deflation, and commodities became increasingly erratic. The situation becomes even more complicated given that the terms “inflation” and “deflation” have very different meanings and imply different policies for different economists.

A few paragraphs down I begin my discussion of various forms of “good” and “bad” inflation and deflation. “Goodness” and “badness,” is meant relative to a laissez faire or “bottom up” approach to economics commonly referred to as the “Austrian School.” I agree in principle with the Austrian School that when we search for truth, there should be no philosophical “disconnect” between the “bottom up” fundamentalist principles of microeconomics that apply to small businesses and Generally Accepted Accounting Principles (GAAP) and the national macroeconomic policies practiced by government and central banks. Therefore, the Austrian school provides an invaluable perspective that I return to repeatedly in increasing detail throughout this series.

The late Dr. Roy W. Jastram of UC Berkeley published a now out-of-print landmark study of gold price behavior titled The Golden Constant – The English and American Experience 1560-1976. Franklin Sander, a Tennessee-based gold dealer, posted data from his book on the Internet. In addition, I have supplemented his data with additional data and commentary (provided by the time periods covered by hyperlinks) by market strategist Dan Ascani:

Dr. Jastram felt his data demonstrated a “retrieval phenomenon” where “gold prices do not chase after commodities; commodity prices return to the index value of gold over and over.” He demonstrated that for short time periods, gold, commodities, and inflation do not necessarily move together, although he concluded that gold has maintained its value in terms of real purchasing power in the very long run. His data also shows how gold tended to do well in periods of deflation during the era of the gold standard.

The stagflationary 1970’s provide an important precedent in recent American financial history, particularly since I believe the decade ahead will echo the 1970’s, only worse. After Nixon removed the dollar from the $35 an ounce international exchange rate in 1971, gold began a run up that culminated at a London PM fix of $850 an ounce Jan 21, 1980. This might be interpreted as a variation of Dr. Jastram’s “catch-up” theme. As a prelude, broad money supply growth (M3) had increased to around 10% a year during much of the Johnson administration (Nov 1963-Jan 1969) and the Nixon years (Jan 1969-August 1974). In the mid to late 1960’s the Fed kept a lid on the price of internationally-traded gold during an episode called “The London Gold Pool” in which it sold off U.S. gold reserves as part of a campaign to help keep inflation indicators suppressed while Johnson was simultaneously funding the Great Society programs and the Vietnam War. Eventually the lid blew off of government and Fed intervention. More on this in Part IX, “The Leviathan State: From Consolidation to Excess.”

It is also worth noting that the period from 1951-1979, not to mention most of the other economic periods provided in the chart above, actually consisted of several distinct economic phases that need to be analyzed in detail before one can draw rigorous conclusions. The data is provided here simply to help provide an intuitive overview.

To get a sense of how different phases of the business cycle impact on the price of gold, we must first disentangle the very different and often confusing meanings of the terms inflation and deflation that are bandied about by the government and national media.

The Honorable Humpty Dumpty: “When I use a word, it means just what I choose it to mean –neither more nor less.” Alice responded: “The question is whether you can make words mean so many different things.” The Hon. Humpty Dumpty replied: “The question is, which is to be master – that’s all.”

Bad inflation. This type of inflation typically means an expansion of the money supply and bank credit ahead of gains from productivity and asset growth. More money and credit chasing fewer goods and services typically means higher prices over the long run.

The public often thinks that light to moderate bad inflation is good for the overall economy both in the short term and the long term. It usually thinks that any degree of bad inflation from its inception is automatically good for gold. Both beliefs are demonstrably false in many if not most cases.

Government and central bank spokesmen typically call this good inflation. They claim that credit expansion and government deficit spending “stimulus” helps to generate full employment and full capacity utilization. This in turn supposedly generates additional earnings and economic growth that offset any increased indebtedness and long-term price inflation.

From their “top down” macroeconomic vantage point, this is definitely good inflation to the extent that it allows government and Fed officials to create money and bank credit out of thin air and spend heavily without the aggravation of overtly raising taxes and receiving immediate negative political blowback.

One reason why this is really bad inflation is because it results in an eventual loss in real purchasing power for the average consumer. This is a hidden form of taxation. Creating more money and credit per se does not in itself create any new wealth any more than a counterfeiting ring. The act of simply increasing spending and the process of creating more useful goods and services in a balanced economy are usually two very different things. “Stimulus” spending typically creates the short-term illusion of prosperity at the long-term price of distorting the economy and debauching the currency.

In the short run, the price inflationary impact of new money and credit is usually muted and ignored by most investors. One reason often involves governmental deceit. The article “They Are Lying to Us Again,” archived at www.jimrogers.com describes how government can selectively edit and misrepresent statistics.

Price inflation may also remain initially muted because excess liquidity can first find its way into stock, real estate, or bond asset bubbles. It may experience a prolonged delay in running up commodity and consumer prices.

Lastly, price inflation has been reduced because the dollar has served as a global reserve currency since World War II. Dollars currently comprise around 68% of global reserves. Foreign banks and trade surplus partners have been willing to sop up excess dollars for their own reserve needs or to try to humor the “last remaining global superpower.”

Gold has historically been slow to react to the initial onset of bad inflation. A likely reason is that the first waves of broad money supply and credit growth (M3) tend to give a false impression of economic health. M3 growth may take longer than a year to begin to show up in price increases for consumer goods. In the initial phase of this cycle, banks acquire more deposits, and in turn have more money to lend. Spending increases, corporate earnings may rise, and the stock market may be spurred on by accelerated business activity.

As business activity picks up, the Fed may hike interest rates ostensibly to “cool the economy” while insisting that it has inflation tightly under control. Higher bond yields look even more attractive relative to gold bullion, which pays no interest.

So-called “bond vigilantes” at major investment firms may insist that the free market is raising bond yields at the “whiff of inflation,” and this in itself is adequate to help cut back excessive monetary growth. The public usually buys off on this, and ignores the fact that investment houses have their own axes to grind.

Investment firms typically want to avoid “unnecessarily” scaring their fixed income clients into another asset class such as gold that could help dry up their bond business. Their bond departments are usually major profit centers. Investment firms often use the attractiveness of bonds for conservative investors as a means to open up new accounts and build up their asset base.

Elderly people, who control a major portion of this country’s wealth, tend to perceive gold and other commodities as volatile and risky. It is not uncommon for an elderly person to shop long hours among brokers to get an extra 50 to 75 basis points in bond yields. He may need to be almost hit over the head with very strong gold trend evidence and very bad inflation news before switching over to gold. We may be talking about the kind of person who is becoming increasingly reluctant to drive at night.

In Part X of this series I discuss evidence supplied by the Gold Anti-Trust Action committee that major investment firms have other conflicts of interest. As two examples, they have apparently been in bed with the Fed through the repurchase agreement market that provides backup support for them to manipulate certain markets. They also need to retain access to Long Term Capital Management-type Fed bailouts to deal with the high risks entailed by their very profitable hedge fund clients.

Adam Hamilton charts the short term paradox where a rise in interest rates can hurt gold in the short run in his July 20, 2001 article “Real Rates and Gold.” In the long run, higher interest rates should coincide with rising real inflation, and motivate people to buy more gold as a hedge against inflation. However, in the short run, if people think that interest rate increases are not part of a sustainable rising trend, they may sell off their gold and drive it lower and jump into bonds to try to capture higher yields. Once it becomes more obvious that inflation is very real, is rising, and is no longer containable, then gold starts moving up along with long-term interest rates. But that usually comes very late in the bad inflation cycle.

Fraud Note: Usually government and central bank authorities never admit that spending stimulus and credit expansion is “inflationary,” in fact, quite the opposite, even though M3 growth may already be showing an upward diagonal line on the money supply charts for a number of years. Inflation is always politically unpopular, and politicians typically have to be dragged kicking and screaming to admit to it. In addition, government tends to be a heavy borrower, and does not want to hike its own interest rate burden. Nor it is anxious to index upwards retirement, Social Security, and other transfer payments in the social welfare state. Nor does it want to excite union members and other workers into hiking wage demands. To the contrary, inflation has always been the government’s sneaky way of dropping real wages to bring the labor supply and employer demand curves in alignment and increase employment while pretending to be “doing something” to stimulate the economy and boost wages.

According to “Austrian” economists, the short-term illusion of heightened economic health created by the “stimulus” spending equivalent of a “counterfeiting ring” has other negative ramifications. M3 growth creates false pricing signals that can seriously distort the economy and undermine entrepreneurial calculation and capital formation. “Austrians” argue that artificial stimulus and artificially low interest rates encourage speculative and wasteful economic activity precisely at that time in the classical economic cycle when the write-down of bad debt and more savings and more prudent investment are required. “Stimulus” tends to help sweep underlying problems under the rug where they may fester and grow larger.

But even worse than false pricing signals and governmental deceit, however, is the ability of the Fed and US Treasury to actively engage in active interventions that further distort and compromise the free market. According to the Gold Anti Trust Action Committee (GATA), the Fed has orchestrated central bank dishoarding to artificially suppress gold to create the illusion of low inflation. GATA also believes that through the repurchase agreement market, the Fed has induced its Wall Street allies to use the gearing of futures contracts to suppress the price of gold and silver even further. As previously mentioned, bullion dealer Blanchard & Co. has filed a $2 billion law suit alleging that J.P. Morgan Chase and Barrick colluded in an artificial gold price suppression scheme.

Good inflation: Since I am discussing opposing concepts, I necessarily have to mention “good inflation” to complement the aforementioned discussion of “bad inflation.” The only problem is that I have never seen anyone discuss such as thing as “good inflation” in this context. At the risk of sounding academic, “good inflation” could mean adding new assets to the system (asset “inflation” in the sense of asset accretion or asset accumulation) while keeping the money supply roughly the same, such as doubling the land mass of the U.S. for nominal cost under the Louisiana Purchase or adding more manufactured goods without raising prices due to enhanced production methods. These accretions tend to drive down average prices while adding tangible wealth and would tend to have the same positive impact as good deflation mentioned later.

Bad Deflation: This is the kind of environment where gold often outshines all other asset classes, and merits extended discussion. This is the overall underlying environment I believe we have been in since the Nasdaq top in March 2000, and it could last for many more years. But first some background on the bizarre situation that currently exists with both the gold market and the stock market.

Bad deflation is typically the back-side of the aforementioned bad inflation cycle, where over-inflated asset prices created by excessive “stimulus” start coming down. As discussed in my paper “Amidst Bullish Hoopla: A Behind the Curtain Look at Fed Desperation and Intervention Wizardry,” where I describe stock market overvaluation in more detail, the Fed has been fearful that if the stock market bubble starts deflating too quickly, this could lead to a negative wealth effect, reduce consumer confidence and spending, undermine bank collateral, dramatically increase bankruptcies and unemployment, and risk a depression. However, by dropping the Federal Funds rate down to 1% and by gunning the money pump by about 10% a year over the past few years to stave off asset bubble deflation, the Fed has risked creating more bubbles elsewhere, such as in the real estate and bond markets. This money supply growth has been showing up in rising consumer prices. This is the type of inflation that the Fed and US Government try to ignore. Hence, we are now simultaneously experiencing consumer price inflation while witnessing overvalued stock, bond, and real estate markets that threaten serious deflation.

As a response to the Fed’s alleged anti-deflation activities (and related factors), the S&P 500 has risen about 43% since March 2003. Conversely, as a response to fears about long-term inflation (and related factors), the un-hedged gold stock index (HUI) has climbed over 500% in the last three years in a “stealth bull market” that most Wall Street firms have downplayed.

Historically the gold market and the stock market have been negatively correlated. Rising long-term inflation is usually very good for gold, and very bad for the stock market. The bullish activity of both markets may be signaling two completely different outlooks for the US economy.

Negative real interest rates are usually a crucial factor in a bad deflation cycle to account for the out-performance of gold. Negative real interest rates mean that the rate of real inflationary erosion in purchasing power from the long-term impact of the underlying growth of M3 is greater than the nominal interest rates one can get from CDs at the bank. Although Americans have been in a negative real interest rate environment since at least the mid- 1990’s, it has become particularly dramatic since the Fed reduced the Federal Funds rate down to 1% by summer 2003 while maintaining broad money base (M3) growth in the 8-10% a year range.

An important cause of negative interest rates is central bank intervention. Let us compare how interest rates set by the Fed may differ from those that might be created by a free market. The Fed has dropped its Federal Funds rate to a 45 year low of one percent to ostensibly stimulate the economy to avoid a collapse of puffed-up asset prices. The Thirty Year Treasury bond hovered around 4.9% as of mid Jan 2004. In my Amidst Bullish Hoopla article, I discuss how hedge funds can work with the Fed and allied Wall Street firms to transmit lowered interest rates out the yield curve with the bond carry trade. Also, the Fed can use Open Market Operations to buy bonds to prop up bond prices and drive interest rates down, often by making purchases with money created out of thin air that ultimately create a hidden tax on the average American.

Contrast all of this with M3 growth, a truer indicator of real long-term inflation. This has been growing between 7%-10% a year since 1995. Let’s say 8% on average. If the free market were to price a bond, it would probably take into account this truer long term inflation rate, and add on top of that a risk premium of let’s say a historical average of around 2.50% . That gives us 10.5% as a rational hurdle rate for setting a free market floor on expected interest rates. Now, let’s deduct the aforementioned Thirty Year Teasury rate of 4.9%, and we get a possible real negative interest rate of 5.6%. For individuals in money market funds that pay less than 1%, the negative spread could be over 9.5%.

Gold, which pays no interest but has the potential to appreciate, starts to look very attractive compared to the negative real rates of return on bonds, CDs, and money market funds. Better yet for gold, if interest rates eventually go up, the resale value of bonds will come down, giving bond investors double black eyes. They will lose both from their low rate of current interest income combined with capital losses on the reduced resale value of their bond holdings. (When interest rates go up, bond resale values go down). Conversely, to the extent that rising long term interest rates signal rising long term inflation, this becomes another plus for gold. Last, but not least, once investors sense that stocks have peaked and may be set for a price decline (deflation), gold and other “commodities” begin to look relatively more attractive. We live in era of central bank and government intervention whose continuous stimulus efforts to arrest asset price deflation are likely to add inflation to the pro-gold story.

There is evidence that markets may tend to be inefficient in adjusting to an environment of continually rising interest rates. British economist Prof. Tim G. Congdon noted in his WGC research study no. 28: “As the double-digit annual inflation rates of the 1970s came as a shock to savers, it took them time to catch up with the new investment paradigm. Interest rates lagged behind inflation and real interest rates became negative, creating the ideal conditions for rising prices of gold and other so-called "hard assets" (oil, real estate, commodities).”

Fraud note: From the Austrian viewpoint, bad inflation cannot go on forever, even as a way to stave off bad deflation. Bad inflation stimulates speculative mal-investment, excessive debt, and asset bubbles that distort the economic system while debauching the currency. The economy may become so distorted that new waves of money only generate stagnation and inflation (“stagflation”), analogous to a drug addict whose fixes start breaking down the body. Since summer 2003 the M3 growth and money velocity charts have been tapering off, partly because the system is getting so saturated with cheap credit that the Fed is beginning to push on a string. Also, a debauched currency may trigger a currency crisis (a rapid exchange rate slide) that can cause foreign imports (10% of US GDP) to become more expensive and contribute towards prolonged malaise.

Austrians believe that often the best thing to do is simply leave the economy alone and allow the free market to sort things out. Go ahead and let asset bubbles deflate on their own. After a period of brief but intense pain from bankruptcies and collapsing prices, entrepreneurs and other bargain hunters typically step in, reshuffle assets into more productive enterprises, and economic growth will start again. That actually happened in America during the Martin Van Buren administration (1836-1840) that experienced a sharp stock market correction and a money supply contraction of 30%, somewhat similar to the first two years of the Great Depression beginning in 1929. The US Government actually reduced its spending during this period, and the economy turned around at the end of the painful two years. (c.f. Dr. Jeffrey Hummel, “Martin Van Buren: What Greatness Really Means”). In contrast, the Great Depression dragged on from 1929 to the 1940’s despite the Hoover administration interventions and FDR’s New Deal. Dr. Murray Rothbard claims in America’s Great Depression that government intervention actually served to prolong and deepen the Depression, and in fact created a second depression within the Depression.

I consider the aforementioned two paragraphs a “fraud note” under the theory that many senior government and banking officials in America are aware of all of this, but are afraid to educate the public for fear that this could lead to the curtailment of pork spending and central banking special privileges that I describe in Parts VIII and IX about the history of gold in America.

Good Deflation: This involves price level declines from improved efficiencies and from asset accretions. The money supply is held relatively constant. Earlier I discussed how the Industrial Revolution helped drive down prices while Britain was on the gold standard. It helped double the purchasing power of the British Pound over a one hundred year period. When currency is pegged to gold, price deflation must by definition be good for gold. Today we see another dramatic example of good deflation in the computer chip industry in which computing power has steadily declined in price in accordance with “Moore’s Law.”

America is also experiencing a form of price “deflation” from low cost imports from Asia, which actually retard the rise in American consumer prices. I hesitate to label this “good” deflation because of many complicating issues. The theory of international free trade is supposed to enhance the wealth and prosperity for all parties involved, and not result in the lopsided situation we see in America today with a serious loss in its jobs and its manufacturing base and a dangerous rise in debt. (A worthy discussion of these issues would require another paper).

Most countries today inflate their money supply at much faster rates than productivity gains. This submerges the gradual accretive effects of good deflation on the price action of gold. The big moves in gold prices usually pertain to other factors such as the deflationary side of business cycles, central bank interventions, fears of runaway inflation, and changes in currency exchange rates.

In August 2003, Newmont Mining President Pierre Lassonde commented: “Eighty percent of the variability of the gold price is due to the U.S. currency valuation. So where the dollar is going is the key determinant of the U.S. dollar gold price. And when you look at the structural imbalances in the U.S. today, they are no different than they were 12 months ago -- in fact they are worse,"

A decline in the dollar can help create a rising floor underneath the price of gold due to an arbitrage principle often referred to as the “Law of One Price.” This can apply to other high unit value, highly transportable goods in addition to gold.

Here is an example of how it might work: Suppose that $1 US dollar equals 1 unit of Foreign Currency (FC). Imagine that ounce of gold sells for US $400. An ounce also sells for FC 400 units. Now suppose as a result of a dollar slide, US $2 now equals FC 1 unit, but the gold price has not changed in the US or in the foreign country. I can now buy an ounce of gold for US $400 in the US, sell that gold at an FC bank for FC 400 units, and then swap the FC 400 units for US $800. By repeating this all day long, I would put upward pressure on the price of gold in US dollars, downward pressure on gold in foreign units, and upward pressure on the value of the $US, causing a decline in the $/FC unit conversion rate.

The formula for the arbitrage is: $/ounce of gold = $/FC unit * FC unit/ounce of gold.

If we keep FC/ounce of gold constant, and increase the $/FC ratio because of a slide in the value of the dollar relative to FC units, then $/ounce of gold in the U.S. is likely to go up.

According to gold analyst Paul Van Eeden, currency exchanges changes are more likely to drag gold along than gold prices changes are likely to impact on currency conversion rates. This is because the gold market is relatively small compared to the gargantuan size of currency markets.

While currency exchange movements may have a high correlation with short to intermediate term gold price swings, they do not explain how the price of gold gets calibrated in the first place before the currency change effects kick in. My history of gold in America in Parts VII to IX should give the reader a better sense of how the baseline value of gold can dramatically decline as the banking system reduces its gold reserve requirements and engages in other “demonitization” processes. In addition, currency traders arbitrage against a wide basket of goods, and not just gold alone. Finally, it may be hard to distinguish between how movements in gold prices and currency exchange rates may relate to psychological expectancy effects among traders (also known as a “self-fulfilling prophecy”) as opposed to mathematical relationships based on hard fundamentals.

Analyst Clive Maund has noted that gold has tended to go sideways or slightly down in foreign currencies such as the Euro, South African Rand, and in Australian and New Zealand dollars as they have appreciated while the dollar index has declined dramatically over the last two years. They have indicated a weak but not insignificant “Law of One Price” relationship.

Many gold gurus have noted that the rise in the price of gold denominated in US dollars in the last two years has actually reflected a dollar bear market rather than a real gold bull market. Rick Rule, President of Global Resource Investments Ltd, observes that gold is the only form of money that does not have an inflationary constituency. Currently all of the major industrialized nations of the world, including Switzerland, are debauching their currencies to maintain export competitiveness relative to the U.S. The next major phase of a true gold bull market will probably take place when gold starts moving up against all the major currencies of the world as countries continue the game of “beggar thy neighbor.”.

To better understand currency exchange movements, it is helpful to disentangle their short term, intermediate term, and long term causes. There are many different causes behind a slide in the US dollar than may not be directly related gold, but nevertheless may get transmitted into a rising gold price through the so-called “Law of One Price” arbitrage.

In the short run, currency exchange rates tend to be heavily influenced by investment capital flows. Back in 2000 America received capital inflows in the area of around two to three billion dollars a day from foreigners. One important factor was a desire to participate in the 1995-2000 stock market mania. Anther important factor was a belief by foreign investors that the dollar would continue to remain strong relative to other currencies, and not fall and hurt the value of their non-repatriated US investments. Lastly, many countries have been willing to continue investing their trade surplus dollars in US securities to stay in the good graces of the world’s “last remaining superpower.”

The US stock and bond markets remain a risky bet that foreigners will continually hold rather than eventually bolt for the door. The S&P index is trading at a P/E multiple that is more than twice its historic average. Its reported or “pro forma” earnings are often twice “real” (or GAAP or core) earnings, as noted in my article “Bear Case Overview.” Also, bond interest rates, at 45 year lows, seem to have nowhere to go but up. A Forbes magazine charticle “Here We Go Again” suggests that the US market could still be mimicking the early phases of the Japanese market of the 1990’s. If the secular bear market that may have begun in March 2000 returns, it could scare foreigners into selling off their US securities and put further downward pressure on the dollar.

In the intermediate term, exchange rates tend to fall in line with the Purchase Power Parity concept. The Economist Magazine’s Big Mac Index uses the Big Mac hamburger, representative of a basic consumer item sold in over 118 countries as a rough yardstick to help calibrate relative currency under-valuations or overvaluations. In 2002 it signaled that the dollar was very overvalued. Li Lian Ong, Senior Analyst at Macquarie Bank, has authored The Big Mac Index. According to the Amazon.com review of her book, the index “…Could have been used to predict the Asian Currency Crisis and the Mexican Peson stand-off where more traditional economic measures failed.”

In the long run relative currency valuations relate to different rates of productivity gains and different levels of monetary discipline of different countries. They bear a rough analogy to relative values of shares of stocks in companies, in which inflation is similar to stock dilution and rising debt is bad (to include trade deficits) if it increases at a faster rate than sustainable earnings growth (analogous to GDP growth). Professor Tim Congdon, Director and Chief Economist of the economics consultancy Lombard Street Research in London, published World Gold Council Research Study 28 in 2002 which he modeled such factors as debt to GDP ratios, interest rates, and growth rates for the US. He cites three reports predicting the strong possibility of a serious currency slide (more on this later), and asked whether the US could make the Herculean shift of 5% of GDP to exports fast enough to halt deteriorating balance of trade and indebtedness trends.

The fundamental outlook for the US remains negative in this area. The declining dollar is likely to have only a marginal impact in correcting America’s balance of trade problems. America has lost about half its manufacturing jobs in the last thirty years and is addicted to foreign goods, plus certain foreign producers such as China and Japan loosely devalue or peg in line with the dollar decline to maintain their export competitiveness. There is no credible evidence that the Federal Government can rein in runaway spending on any level, be it military or social, and is arguably already bankrupt (discussed in more detail in Part V). Fed Governor Ben Bernanke has announced that the Fed is prepared to inflate without limit to smooth over problems. Asian demand is putting steady upward pressure on commodity prices, which will likely squeeze American incomes. China is becoming increasingly capable of fueling its growth in Asia independently of the US, and Chinese investors may become less inclined to support America’s trade deficits and use their capital instead to fund internal growth. Other foreigners will likely cut back on their US investment for fear of suffering further losses from continued US dollar declines.

Eventually, to fund America’s growing deficits, the Fed will have to accelerate money creation to monetize part of America’s debt and also hike interest rates to try to lure foreign investment back. Rising interest rates will likely slow the economy and hurt the stock, bond, and real estate markets. The magnitude of America’s trade deficits and indebtedness suggest that the US will eventually wind up with double-digit interest rates and hyperinflation.

I have already discussed in my “bad deflation” section how gold tends to be a late bloomer in the bad inflation cycle, often trailing commodities, and how it tends to benefit in a negative interest rate environment. James Turk’s commodity chart shows us the explosive “generational” bull market in commodities that took place in the stagflationary 1970’s. This followed the sideways commodities markets of the 1950’s and 1960’s. This raises an interesting question regarding how explosively commodities might move in the decade ahead if they become the focus of another generational event proportional to the commodities bear market that lasted from 1980 to 2000.

Like gold, commodities in general can have a dual nature as investment vehicles once investors perceive them as a store of value in an inflationary environment. The 1970’s era even showed how commodities could become the focus of an investment mania.

Interestingly, commodities cycles have been getting longer in the last eighty years, as suggested below by the Commodities Cycles chart provided at: www.ditomassogroup.com. This may be an indicator that we could be entering the early phases of a long term commodities bull market.

We might also note the “generational” 30 year Treasury Note chart below. Please recall that the Fed began to hike interest rates between 1998 and 2000 to help keep a lid on inflation and take some of the speculative air out of the stock market mania. Jim Roger’s article “For Whom the Closing Bell Tolls” criticizes Fed Chairman Alan Greenspan for not hiking margin rates and reducing monetary stimulus much sooner. My guess is that somewhere around or prior to 1998 was probably the real bottom of the generational trend in declining interest rates. The artificially low interest rate environment we have been in since 2000 could simply reflect a postponement of fundamental inflationary realities.

The chart below provided by Michael Landis in his article “The Once and Future Money” that overlays the price action of gold and the exponential rise in M3 and government spending provides another perspective on the rising waters that may be filling a cracking dam to the brim. Eventually, long-term interest rates, gold, and commodities may make a dramatic upward move together as they did in the late 1970’s.

James Sinclair said in a July 20, 2002 interview with James Puplava that he exited gold in 1980 near its top at $850 following its long run in the stagflationary 1970’s. He took his cue when Fed Chairman Paul Volcker hiked short term interest rates to 16%. To Sinclair, this showed that the Fed was finally serious about stopping inflation. This was after the prime rate had held over 20% for over a year. This dramatic Fed tightening created a credible positive real interest rate environment and an air of certainty about interest rate trends (stable to down). All of this was bad for gold, and suggested a top.

Today, even though the M3 growth charts look scary, the government, central bank, national media, and public at large are still in denial. Let us call this stage the Phase I denial stage. We still have at least two more phases to go. Phase Two entails general acceptance of a serious inflation problem. Phase Three entails taking decisive steps to stop the problem, as Fed Chairman Volcker did in the early 1980’s. Using the Sinclair method, one might simply buy gold and silver stocks now and hold until America shows credible evidence of achieving Phase III. This will probably be many years from now.

In his article “To the Moon, Alice!” James Puplava wrote about how in the first phase of a long term bull market, the smart money gets in. Then in the second phase the institutional investors get in. Finally, in the third and last phase, the little guy gets in. Puplava thinks we are in the tail end of phase I.

Mass media publications are often a contrarian indicator for when the little guy is finally catching on. If Puplava is correct, one might still consider accumulating gold and other precious metals stocks now and then wait until someone like Pierre Lassonde, President of Newmont Mining, makes the cover of Time magazine before inserting stop loss orders.

Bill Fox is VP/Investment Strategist and private client money manager, America First Trust. Bill welcomes phone calls and responses to this article. His web site: www.amfir.com. Address: VP, America First Trust, Reg. Rep., Sammons Securities Co., LLC P.O. Box 820669, Vancouver, WA 98682, telephone: 360-882-5369, toll free: 866-945-5369 (866-WILL FOX), email: wfox@sammonsrep.com. Securities offered through Sammons Securities Co LLC, member NASD and SIPC. © 2004 Bill Fox. Additional Disclaimer: Not all views referenced in this report are necessarily those of the author, America First Trust Financial Services, or Sammons Securities Co., LLC. Sometimes the author provides opposing viewpoints to give the reader a greater sense of perspective. This report is intended for informational purposes only and should not be considered specific investment advice. It is not intended to be a recommendation to buy or sell securities in the absence of specific knowledge regarding the financial situation and suitability requirements of a reader. The information has been obtained from sources believed to be reliable but whose accuracy cannot be guaranteed. Past performance is no guarantee of future results. There can be no guarantee that the market will perform according to the author's opinion or that his investment ideas will be effective under all market conditions. His opinion can change without notice. Investment returns will fluctuate and the value of an investor's positions may be worth more or less than the original cost when redeemed. Market data presented here is subject to change daily. Sammons Securities Co., LLC is a member of the National Association of Securities Dealers (NASD) and the Securities Investor Protection Corporation (SIPC).

DISCLAIMER: Not all views referenced in this report are necessarily those of the author, America First Trust Financial Services, or Sammons Securities Co., LLC. Sometimes the author provides opposing viewpoints to give the reader a greater sense of perspective. This report is intended for informational purposes only and should not be considered specific investment advice. It is not intended to be a recommendation to buy or sell securities in the absence of specific knowledge regarding the financial situation and suitability requirements of a reader. The information has been obtained from sources believed to be reliable but whose accuracy can not be guaranteed. Past performance is no guarantee of future results. There can be no guarantee that the market will perform according to the author's opinion or that his investment ideas will be effective under all market conditions. His opinion can change without notice. Investment returns will fluctuate and the value of an investor's shares may be worth more or less than the original cost when redeemed. Market data presented here is subject to change daily. Sammons Securities Co., LLC is a member of the National Association of Securities Dealers (NASD) and the Securities Investor Protection Corporation (SIPC).