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
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
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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