Is the current rise in the gold price sustainable?
March 26, 2004

Many gold investors (myself included) buy the metal as a form of insurance. In my case, gold is not insurance against social or political perils like the railway bombings in Madrid or Israel’s assassination of Sheikh Ahmed Yassin -- some of the factors behind gold’s increase this month.

Political or social violence is unpredictable, which is why investing in anticipation of it is a bad idea. Political and social violence is also relentless, which is why people adapt to it, and why the market’s reaction to violence is usually a short-lived phenomenon.

No, the reason I am in the gold sector is the transformation that’s occurring in our international monetary system. Since 1944 the US dollar has been the world’s official reserve currency, allowing the United States to inflate its currency with impunity while other countries have to bear the cost of their financial and fiscal indiscretions. With the establishment of the euro, and with growing resentment toward US Foreign Policy, we are witnessing the conclusion of the dollar’s reign.

Even if the demise of the dollar is going to take many decades to unfold, the dollar has a severe short-term problem. This problem has a name: Trade Deficit. And in this case short-term means five to ten years, about the extent of my investment horizon.

The trade deficit alone is a virtual guarantee that the dollar will decline on foreign exchange markets. No country, company, household or individual can consume more than what it produces for any extended period of time without getting into trouble. If you don’t believe me, try.

Individuals and corporations that consume more than what they produce (earn) have to fund their deficits with debt. Sooner or later, depending on how crafty they are, the debt catches up with them and either they, or their lenders, have to account for that debt. In the United States we have record personal debt levels and record corporate debt levels. No wonder we also have record bankruptcies in both courts.

The United States as whole is consuming more than what it’s producing, as evidenced by the trade deficit. The magnitude and endurance of the trade deficit is an indication that there exists a distortion in the world’s monetary system. The root of that distortion is easy to identify, and to correct.

The US dollar more than doubled, on average, against foreign currencies during the 1990s. As the dollar strengthened imports became cheaper and exports more expensive. So American companies did the rational thing: they imported more and exported less (the latter was, for the most part, involuntary). This lead to the expansion of the US trade deficit from a mere thirty one billion dollars in 1991 to five hundred and forty billion dollars last year.

Some economists argue, however, that a country can sustain a trade deficit because all that really happens is that foreign investment buys up local assets. That is, the trade deficit does not have to be financed with debt since you can sell equity instead. That is certainly true; it is true of corporations and individuals also, except they tend to run out of assets much faster than a country does. Keep in mind, though, that no country has ever been able to correct a large trade deficit without going through a recession, the magnitude of which is directly proportional to the extent of the trade deficit. And no trade deficit has ever been as large as the one the United States currently has.

One consequence of a prolonged trade deficit is the loss of jobs -- something that has, not surprisingly, recently become a political issue. An increase in unemployment puts stress on the economy and ultimately leads to a recession, decreasing demand for all goods, including imported goods. The recession also makes local assets less attractive to foreign investors, especially when coupled to a trade deficit since output is restricted to a local, malaise economy. So foreigners stop financing the trade deficit, causing the currency in question to decline. The falling currency (dollar in this case) makes imports more expensive and exports more competitive, setting the stage for the economy to get back on track again. The trade deficit, the boom years (remember the Nineties?), the ensuing recession, and the fall of the dollar are all parts of the same cycle. You cannot extricate any one component from the rest.

So regardless of what the popular press would like us to believe, the economic recession in the United States is far from over; it has hardly even begun. Until we see the trade deficit eliminated there remains considerable risk in the US economy. And the elimination of the trade deficit is unlikely to occur without a severe decline in the dollar, which, in turn, will lead to an increase in the dollar-gold price.

How the price of gold will perform in any other currency is largely a function of how that currency will perform against the dollar -- each currency’s exchange rate is an indication of the strength and attractiveness of its economy versus that of the United States. I wish I could tell you what the gold price will do in euros, yen, rands, etc., but I don’t yet have the answers to all those questions -- mostly because much of the data required to answer those questions is simply not available, to me at least.

Now it seems that some readers are confused by the fact that I believe we will see gold trading at a thousand dollars an ounce within five years or so, while at the same time I am cautious about the current market. Nothing goes straight up, or straight down. Skepticism is your friend when it comes to investing, and that includes being skeptical about your own beliefs. While I remain aggressively exposed to the gold market I am also concerned that the gold price, in the short term, has been moving up for psychological reasons associated with the threat of increased terrorist activities, and not fundamental reasons, and could reverse course on a moment’s notice.

Gold as money
As the international market replaces the US dollar as its reserve currency, the euro is one alternative and seems to be making headway in that direction. But there is also a renewed interest in gold, especially from the Islamic world. After all, why should they settle their trade in either euros or dollars?

I used to believe that a return to the gold standard was necessary to curb government abuse of currencies, but I have come to think that all we really need is the freedom to choose our own currencies. In a free market, those of us who believe that gold is a superior currency to fiat money could open accounts with e-gold (www.e-gold.com) or Gold Money (www.goldmoney.com), for example, and manage our affairs as we see fit. The establishment of gold-backed, electronic currencies such as these is definitely the first step in the right direction, although the gold-money industry is still in its infancy.

The concept of private money, specifically gold, is not a new one. I found an interesting interview with President Ronald Reagan on this topic on Joe Bradley’s Investor’s Hotline website (www.investorshotline.com/guest.html); it’s worth listening to. Joe also interviewed yours truly and you can listen to that interview at www.investorshotline.com/pve.

I will be in Calgary next month (April 24th and 25th) at the Cambridge House Resource Investment Conference and in London on May 4th and 5th. Links to these events are in the column on the left. If you happen to attend any of these conferences please find me and introduce yourself.

Paul van Eeden

Paul van Eeden works primarily to find investments for his own portfolio and shares his investment ideas with subscribers to his weekly investment publication. For more information please visit his website (www.paulvaneeden.com) or contact his publisher at (800) 528-0559 or (602) 252-4477.

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