Hera : US dollar

Interview: Eric Sprott on Gold and QE2

Ron Hera — Mon, 18 Oct 2010 09:23:00 GMT

The Hera Research Newsletter (HRN) is pleased to present the following exclusive interview with Eric Sprott, Chairman, Chief Executive Officer and Chief Investment Officer of Sprott Asset Management LP and Chairman and CEO of Sprott Money, Ltd. With over 35 years of experience in the investment industry, Mr. Sprott is the Senior Portfolio Manager for numerous funds comprising several billion dollars in assets.

After earning his designation as a chartered accountant, Eric entered the investment industry as a research analyst at Merrill Lynch. In 1981, he founded Sprott Securities (now called Cormark Securities Inc.), which today is one of Canada’s largest independently owned securities firms. After establishing Sprott Asset Management Inc. in December 2001 as a separate entity, Eric divested his entire ownership of Sprott Securities to its employees.

Eric’s investment abilities are well represented by his track record in managing the Sprott Hedge Fund L.P., Sprott Hedge Fund L.P. II, Sprott Bull/Bear RSP Fund, Sprott Offshore Funds, Sprott Canadian Equity Fund, Sprott Energy Fund and Sprott Managed Accounts. In December 2004, the Sprott Hedge Fund L.P. was awarded the Opportunistic Strategy Hedge Fund Award at the Canadian Investment Awards. In addition, the Sprott Offshore Fund Ltd. won the 2006 MarHedge Annual Performance Award under the Canada-Based Manager category. Furthermore, in October 2006, Eric was the recipient of the 2006 Ernst & Young Entrepreneur of the Year Award (Financial Services) and the 2006 Ernst & Young Entrepreneur of the Year for Ontario. In December 2007, Eric was named Fund Manager of the Year by Investment Executive, a widely circulated publication for Canadian financial advisers. In October 2008, the Sprott Offshore Fund Ltd. won the award for the Best Long/Short Hedge Fund globally by HFM Week, a leading publication for the global hedge fund industry.

Eric’s predictions on the state of the North American financial markets have been captured throughout the last several years in a series of investment strategy articles entitled “Markets At A Glance”.

Hera Research Newsletter (HRN): Thank you for taking the time to talk to us today. You’ve commented in your articles and elsewhere that the financial problems of the United States are much more serious than one might imagine based on the official statements of the US government.

Eric Sprott: The situation goes back at least to 2000 when we saw the Nasdaq rolling over. Before it rolled over, we’d written about it, in fact, we almost to the day published an article entitled “Speculation is Rampant, Don’t be a Part of It”. From that point on, I’ve believed we’re in a secular bear market. The Nasdaq certainly has been in a secular bear market since then. Somehow they resurrected the S&P and the Dow but in order to do it they had to start a housing mania and a lending mania and now, a government spending mania. We still think that the situation peaked in 2000 and continues today in a secular bear market, but it’s morphing into a bigger problem.

HRN: What is the bigger problem?

Eric Sprott: The bigger problem that we have today is where the sovereign risk stands and the size of the US deficit and I think that the question today is “Does Keynesianism work?” In other words, if you spend money it’s supposed to stimulate your economy, but there have been a number of reports suggesting that the opposite happens, that you get a negative return for government spending. One study was done in Canada by the Fraser Institute and another was done by three Harvard professors and their conclusions were that government spending was not good for private enterprises, period. You can see this if you look at a chart showing the marginal value of each dollar spent by the US government from 1960 to today.

HRN: Do you mean the marginal return on a dollar of debt?

Eric Sprott: The marginal value of government expenditures, yes, debt, essentially the deficit spending. The economic effect of running deficits is now something like negative 40 cents on the dollar. I think Keynesianism is sort of being stood on its ear and it seems quite likely that there is a negative return on deficit spending. For example, if the US government extended unemployment insurance benefits yet again, what do we all think the people receiving unemployment benefits would do? Would they be rushing out to get a job or not rushing out to get a job? You see, deficit spending almost always works against the system. When I look at US GDP, which I think last year probably went up by $400 billion, but, at the end of the day, there was an extra debt of $1.5 trillion and this year it will probably go up by the same amount, any thinking person would realize that if you tack on $3 trillion of debt and you’ve got less than $1 trillion of GDP growth, that’s a formula for bankruptcy.

^{Chart courtesy of} ^{Nathan A. Martin}

HRN: Are you saying government stimulus doesn’t work because debt rises faster than GDP?

Eric Sprott: Yes, it doesn’t work. I’m not even including debt at the state and municipal levels. I’m just using federal debt. Debt at other levels of government in the US is going up too, but not at the rate the federal government debt is increasing.

HRN: What sort of outcome or endgame do you foresee?

Eric Sprott: A few months ago, I wrote an article entitled “Surreality Check Part Two… Dead Government Walking” where I specifically zeroed in on the US government. When I wrote Surreality Check … Dead Men Walking back in November of 2007, I predicted that some companies—I pointed out Citigroup, GM, Fannie, Freddie—were all broke. They had pretty good market caps at the time, but the reality was that they were broke and I think the reality is that the US government is broke. If you take all of the unfunded liabilities—the number is something like $60 trillion or $100 trillion—there’s absolutely no way that it can be repaid. They’re going to have to repudiate some obligation, just as other governments are doing now. For example, the UK and France and maybe even Germany all extended the number of years you have to work before you get a pension. There is a sense of repudiation of what they promised and that will have to happen in the US as well.

HRN: Is debt monetization a repudiation of debt?

Eric Sprott: All of history says we shouldn’t trust government, so why do we trust the money that the government says is worth something when the history of governments is one broken promise after another? The only thing they’ve done, over the last 90 years or so, is to keep gouging the taxpayer, while at the same time racking up increasing debt. There’s very little responsibility at the government level for the financial well being of a country in the long run. Fiat money will all go back to its intrinsic value, which is zero. You need real things to support the valuation of currencies. I find it absolutely shocking that we trust government.

HRN: Since you expect fiat currencies to fall in value, do you also expect real assets to rise in price?

Eric Sprott: I think it depends on the class of the real asset and what determines its value. For example, I always question real estate because a lot of real estate is so indebted. If people have to pay their debts back you can have real estate going down, even though you might be in QE2 or QE3 by the time, because there’s just not enough cash flow being generated. I think of things like agricultural products, oil and gas. I think of things that can be used as a medium of exchange, such as gold and probably silver, or maybe other precious metals but that’s the category I think is the most survivable in terms of holding its value.

HRN: Is that why you’ve invested in precious metals and gold in particular, to survive the bear market?

Eric Sprott: My history with gold goes back to about 2000 when things were bottoming out there and, in fact, coincided with our belief that we were going into a bear market. When you look at any bear market, you think “How do you survive it?” We’ve thought ‘you’ve got to have gold and gold stocks’ and it’s worked out so beautifully that it’s shocking. To think that the markets over the last 10 years are down and gold is up something like 500% and gold stocks are up something like 1200% from their lows. That’s been the place to be.

HRN: It seems a lot of money is flowing into the Sprott Physical Gold Trust (NYSE:PHYS).

Eric Sprott: As it applies to US residents, the tax rate on a capital gain in the Sprott Physical Gold Trust is 15% today whereas if you own the ETF, because gold is considered a collectible by the IRS, the tax rate is 28%. That’s a big reason for people to choose this vehicle versus an ETF. In addition to the tax benefits for US investors, the gold is held at the Royal Canadian Mint in Ottawa and to some people in the US that’s a good thing, because they’d like to see it out of the country. Also, the trustee is not a levered financial institution. The trustees for the gold and silver ETFs are levered financial institutions and therefore, when you have leverage there’s always potential risk. Of course, the reason we started it was that a lot of people realized there’s so much paper gold around that when you go to claim your gold it’s not going to be there.

HRN: I understand there’s a premium of between 5% and 10% for shares in PHYS over the spot price of gold.

Eric Sprott: We wanted people to be able to literally get their physical gold, so there’s a mechanism where, if you can buy a bar, which is 400 ounces, we will deliver it. The physical quality of it—the knowledge that the gold is there—in addition to the tax advantages, creates the premium. I think it’s justified. There are certainly no other North American vehicles where you can get physical gold. That’s why we created this vehicle.

HRN: So, there’s a level of insurance that’s just not there with ETFs like GLD. Do you view gold purely as insurance or do you also view gold as currency?

Eric Sprott: When I first got involved in gold, I came to the conclusion, based on Frank Veneroso’s book, The Gold Book Annual 1998 (Jefferson Financial, 1998), that the gold market was being suppressed by central banks and that that logjam had to break. Veneroso proved that there were sellers of about 400 tons a year. Given enough time, their willingness to sell gold had to run out. Now we are in a situation where central banks, which used to be sellers of gold, have become buyers of gold. The gold market is very small. The mines produce, let’s say, 2,600 tons per year and the central banks used to sell 400 tons. That’s a lot of tons in a 2,600 ton a year market. Now, central banks are buyers of probably 200 tons or more. I think the World Gold Council estimated that central banks bought as much as 400 tons last year. Imagine a shift of going from a seller of 400 to a buyer of 400 in a mine supplied market of 2,600 tons. Where are all of the normal users of gold going to get gold with this huge change at the central bank level?

HRN: It’s curious that central banks would have sold gold as the price was declining and are now buying when the price is rising.

Eric Sprott: Now we have gold ETFs, that didn’t even exist 10 years ago, and they are now among the largest owners of gold in the world. There are also funds like ours and Paulson & Co. or David Einhorn’s fund, Greenlight Capital, as well as various pension funds that now own gold but that never owned gold 10 years ago. Where are these funds getting all of their gold when they weren’t even part of the supply and demand equation 10 years ago? I wonder where all of this gold is coming from. I’ve always been suspicious that it’s surreptitiously coming out of the central banks.

HRN: Central banks manage the exchange rates of currencies, which is no secret. If gold is still treated as a currency, the gold exchange rate might be managed, as it was under the London Gold Pool.

Eric Sprott: Central banks can also influence bond markets, and not just government bonds. Last year the US Federal Reserve bought $1.2 trillion worth of mortgage backed securities.

HRN: That was a huge injection of liquidity.

Eric Sprott: We’ve had a huge shot in the arm both in the financial markets and in the fiscal markets, but we took on huge debts as well. The hand of government in everything has been unbelievable and what do we have to show for it as we sit here today? We’ve seen the economic data fall off a cliff: retail sales, new home sales, consumer confidence, the Baltic Dry Index, the Chinese stock market index. I mean, the things that have fallen off the table have been so dramatic and over such a short time.

^{Chart courtesy of} ^{InvestmentTools.com}

HRN: We’re not seeing much of a recovery in the US.

Eric Sprott: In some of the data you’re seeing, no recovery. Housing, for example, is at a dead, flat bottom. I expect that car sales are going to start doing the same thing. In fact, we’re going negative right now: the leading economic indicators, the ECRI Index, I mean everything. You’ve got to think we’re just going straight down, not even slowly.

HRN: You mentioned the heavy hand of government in these massive interventions.

Eric Sprott: The conclusive evidence is that when governments get involved with things, the impact is negative because you get a misuse of funds. It’s like the Fed goes in and buys a bunch of mortgage-backed securities (MBS) so the housing market stays together but if they stop, the housing market collapses because it was a misallocation of resources. We should not have been encouraging people to be buying houses. We should have been doing the opposite: saving money. We have to learn to save here both at the individual level, the corporate level and at the government level. The government is giving all the wrong signals, they’re getting the wrong people to do exactly the wrong things and it makes the problem that much bigger.

HRN: Would it be fair to say that, in your view, central planning and the economy is just sort of an ineffective strategy?

Eric Sprott: You know, I think we’d all agree when we hear that statement. Central planning doesn’t work, but then when it comes to our own government, all they want to do is centrally plan even though they don’t think they’re centrally planning, but, by god, they are. The US government is saying that to make the economy go they’re going to run a trillion and a half dollar deficit. If that’s not central planning, I don’t know what it is.

HRN: I think the US national debt is expected to reach $20 trillion. Do you think the US is going to be able to borrow and roll over debt at those levels?

Eric Sprott: Where does the money come from? Theoretically, the money has to come from companies or individuals. If we just took one country and said that they should fund themselves from the earnings of companies and savings of individuals and if there were no way, between the individuals and the companies, that they had the money every year to throw into government, it wouldn’t work. The US government funded itself with debt all of last year and certainly into March of this year. The thinking is that between the Fed buying financial assets in the market and the banks buying government debt and not lending, that they’ve been able to fund the government, but we’re going to find that it’s not sustainable. The process of asking people to be indebted to the tune of a trillion and a half dollars per year just at the federal level is impossible; and to do it several years in a row with the growing legacy of the debt is not sustainable. What if interest rates were where they really should be?

HRN: Do you think that, with a weakening dollar, the real interest rate could be negative right now?

Eric Sprott: This 0% interest rate policy, 20 years from now, will be looked at as one of the biggest financial jokes of all time. Of course, the primary beneficiaries are the banks and the government. Banks can borrow for nothing and the government can borrow for next to nothing, but the true interest rate should be much higher. I mean, what’s the point of saving? You’re asking somebody to save to fund the deficit and then you pay them nothing to save. What’s the point? You get nothing for your savings. Why would people save?

HRN: With a second round of quantitative easing, QE2, do you think there could be a loss of confidence in US government debt or in the US dollar?

Eric Sprott: We have a dilemma staring us in the face and I don’t see an easy way out of it. People will start questioning sovereign risk. It started with Ireland; it went to Iceland; it went to Greece; it’s maybe now with Portugal or Spain and it might be washing up on the shores of North America. As you know, the dollar has been quite weak recently and I think, as more and more people assess the problem, they’ll find that there aren’t many safe sovereign places to go. There just aren’t many. They’re very, very rare. Either there will be no QE2 and interest rates will go higher, or, if there is a QE2, interest rates can stay low, but ultimately, if we then go on to QE3 or QE4, the gig will be up because everyone will realize we’re just printing money and we’re not getting out of this problem. If we’re just printing and printing and printing, people will want to convert their bank deposits to something real because they’ll realize that fiat money is not going to hold its value.

HRN: What do you see as a solution here? What’s the path forward for the world?

Eric Sprott: I don’t think there’s a solution. People always say to me, “When would you not be bearish?” I say, “Well, I won’t be bearish when I see people in the central banking community and in the sovereign area start to take responsibility.” One might argue that maybe we’ve seen the first signs of that over in Europe and the UK and Greece with austerity. What’s interesting is that most of these programs start a year later. They don’t start today. It will be interesting to see when we get there, how powerful those programs will be.

HRN: Are the European austerity measures indirect bailouts, preserving sovereign debt?

Eric Sprott: That’s why they announce them. We saw QE with the ECB when they put a trillion dollars in for the Greek bailout. If they hadn’t announced austerity programs what would we all be thinking? You can’t get the bailout and not at least say you’re going to try to stop spending money. It was almost mandatory for people to say at the time. They all had to chime in because the Euro and the European banking system were under immense pressure. Deposits were leaving those countries, so they had to do something.

HRN: How do you foresee the sovereign debt situation unwinding?

Eric Sprott: I think we’re too far gone. There’s way too much debt. Just the federal debt is something like $40,000 for every American, so a family of four has got $160,000 in debt they’ve got to lug around; and that’s forgetting the states. I don’t think we can work our way out of it. We’ve gone for 60 years by expanding debt and, all of a sudden, that era ends and you have a contraction and the contraction will be rather elongated.

HRN: Thank you for sharing your views with us.

Eric Sprott: Thanks a lot.

After Words

Eric Sprott’s track record as a Portfolio Manager and as an entrepreneur in the natural resource sector speaks for itself. Whether one agrees with Eric Sprott’s skepticism regarding the fiscal responsibility of governments, the soundness of fiat currencies, or the stability of debt-laden companies and sovereigns, his contrarian analysis has enabled him to capitalize on the trade of the decade: gold. Between the anemic US economy, the Federal Reserve’s low interest rates and purchases of financial assets, as well as the US federal government’s deficits, and a second round of quantitative easing (QE2), the US dollar will certainly weaken further, fueling demand for gold.

Interview: Dr. Marc Faber on the Federal Reserve and Hyperinflation

Ron Hera — Fri, 24 Sep 2010 00:07:00 GMT

The Hera Research Newsletter (HRN) is delighted to present the following powerful interview with noted speaker and best selling author Dr. Marc Faber, whose newsletter, The Gloom Boom & Doom Report, highlights unusual investment opportunities. Dr. Faber is a popular speaker at investment seminars and conferences around the world and is best known for his contrarian investment approach.

Born in Zurich, Switzerland, Dr. Faber went to school in Geneva and Zurich and finished high school with the Matura. He studied Economics at the University of Zurich and, at the age of 24, obtained a PhD in Economics magna cum laude.

Between 1970 and 1978, Dr. Faber worked for White Weld & Company Limited in New York, Zurich and Hong Kong and, since 1973, has lived in Hong Kong. From 1978 to February 1990, he was the Managing Director of Drexel Burnham Lambert (HK) Ltd.

Dr. Faber’s best selling book Tomorrow’s Gold – Asia's Age of Discovery has been translated into Japanese, Chinese, Korean, Thai and German. Dr. Faber is a regular contributor to several leading financial publications around the world.

Dr. Faber, who is an investment adviser and fund manager associated with a variety of funds, is a member of the Board of Directors of numerous companies around the world.

Hera Research Newsletter (HRN): Thank you for joining us today. You’ve commented that the Federal Reserve’s policies have been linked to past boom and bust cycles in the US economy. Why do you believe that?

Dr. Marc Faber: Booms and busts happen also under the gold standard like we had in the 19th century various railroad and canal booms, and we also had real estate booms, first on the east coast in Chicago, then, at end of the century, in California. What the Federal Reserve has really done is create a lot of economic volatility. If you look back at the various crisis starting with the S&L crisis in 1990, then the Tequila crisis [the Mexican Peso crisis] in 1994, then Long Term Capital Management (LTCM), the NASDAQ bubble and at the current crisis, each crisis actually became worse and worse and the bubbles became bigger and bigger. The Federal Reserve did not pay any attention to excessive credit growth. The reason I am so negative about the Federal Reserve’s policies is that they only target core inflation and argue that they can’t identify bubbles, but when each bubble bursts they flood the system with liquidity that bring about unintended consequences.

HRN: What would be an example of that?

Dr. Marc Faber: Commodity prices peaked in May 2006 and after May 2006, especially in 2007, where there was actually a slowdown in the global economy and so there was no reason for commodity prices to go ballistic, but the Federal Reserve slashed interest rates after September 2007. In a global economy that was going into recession, the price of oil went from $78 to $147 and that burdened the US consumer with additional “tax” of five hundred billion dollars. I am not saying that is the only reason but it helped push the US consumer into recession. The fact is that without the Federal Reserve’s expansionary monetary policy after 2001, we wouldn't have had a housing bubble to the same extent. The Federal Reserve’s policies basically encouraged sub prime lending; it’s not the case that they discouraged it.

HRN: Is there a relationship between monetary expansion and the fact that the US economy depends so heavily on consumption?

Dr. Marc Faber: Basically, if you look at consumption as a percent of the economy and at housing activity, the excessive debt growth began essentially after LTCM and, I have to say, it was a huge mistake of the Treasury and Fed to bailout LTCM because it gave Market participants in the financial sector a signal that there is a Greenspan put, and later on a Bernanke put, with an even higher strike price and this resulted in excess leverage. So, if you have problems, the Federal Reserve will bail you out or the system will bail you out. That’s where I think the Federal Reserve acted irresponsibly—irresponsibly—that has to be said very clearly. They didn't pay attention to credit growth. Every central banker in the world pays attention to credit growth, but not in the US.

HRN: What would you recommend that the Federal Reserve do differently?

Dr. Marc Faber: The first action Mr. Bernanke should take is to resign. If I had messed up the system so badly, as he has done, I would have to resign. He has talked constantly about the Great Depression and what caused the depression but the problem is that he really doesn't understand what caused the depression, which was also excessive leverage at that time. I have to stress that in 1929 the debt to GDP ratio was of course minuscule in comparison what it is today. It was 186% of GDP but you didn't have Social security, Medicare and Medicaid and unfunded liabilities for Social Security and so forth. So, debt today, as a percent of GDP, is 379% and if you add the unfunded liabilities we are at over 800%. The Federal Reserve should pay attention to that.

HRN: With debt levels and liabilities so high, what solution is there for the United States?

Dr. Marc Faber: The solution is, basically, for the government to move out and not intervene in the economy. There are economists who will dispute that the Federal Reserve is partially responsible for the crisis and there are economists that will still tell you that debt doesn’t matter, that deficits don't matter and they want to continue to intervene in the free market constantly. To these economists I respond: What about Fanny Mae and Freddy Mac? It was an intervention by the government into the housing market and into the mortgage market and the biggest bankruptcies—bigger than Citigroup and all the banks—are Fanny Mae and Freddy Mac—government-sponsored enterprises. The same economists will tell you that the government has to intervene and to these economists I say: Well, you have made so many mistakes already with interventions do you think that in the future your interventions will improve anything? Einstein defined insanity as doing the same thing over and over and expecting different results, but these economists and the Federal Reserve think that by more interventions with fiscal measures and more money printing they will improve things. No, they won’t. They will make things worse.

HRN: It seems the US is moving towards more government intervention into the free market rather than less.

Dr. Marc Faber: Yes. That’s why I’m very negative about economic growth in the US. It just won’t happen. Can the US economy grow at 2% per annum or, in the best case scenario, at 3% per annum with current policies? Yes, but it will create a lot of distortions. The best case for an economy that goes into a boom phase, in other words over consumption, is to bring it back into the trend line as quickly as possible. So when you have an excursion into a boom, what you need is a cleansing of the system and that may take a few years to happen in the US because the excesses were built up not just in the last 7 years between 2000 and 2007 but, over the last 25 years. So, to really bring the US back into sanity—into a healthy mode where the economy can grow—might take 5 to 10 years, but it won’t happen under the Obama administration.

HRN: Given the poor prospects for US economic growth, do you foresee a flight of capital from the United States?

Dr. Marc Faber: You would be out of your mind, with health care reforms and with the government interventions and the uncertainty about future taxes in the US, to even consider expanding in the US and this is a problem. I mean people say that loan demand is down because banks are not lending, but maybe nobody wants to borrow any money in the US and nobody wants to expand in the US but they are expanding in China, India, Vietnam, Bangladesh, Africa and Brazil. The business world is an international place today, and if you run a corporation, whether you employee 50 people or 10,000, you can choose where you invest your money in terms of capital spending. Where do you want to expand factories? If I employed people in the US, I would rather think of reducing the 50 employees maybe to only 20.

HRN: Where should American investors put their money?

Dr. Marc Faber: Different people have different investment objectives but I made a presentation recently where I showed, that in terms of goods markets, the emerging world is now larger than the developed world and so I think people should have at least 50% of their money in emerging economies. With interest rates at zero and with the prospect that they will stay at zero, or below zero in real terms for a long time, I think cash is not particularly attractive. I think US government bonds are unattractive in the long run, although they may be attractive for the next three months. I would recommend to people to accumulate precious metals and invest in a basket of shares in emerging economies.

HRN: Are you saying you would consider buying gold even at today’s prices?

Dr. Marc Faber: Yes, I keep accumulating gold although in the next three months it may go down and not up, but maybe it won’t go down. To me, it doesn’t really matter if it goes down by 10% or 20% or whether it stays where it is. I think if in case gold came down 20% it would be because tightening of global liquidity and, in that scenario, equities wouldn’t do particularly well either.

HRN: You mentioned that cash is not attractive. What are the prospects for the US dollar?

Dr. Marc Faber: The dollar has been relatively weak in the last few years. It’s just that the other currencies are not much better. There has been a tendency for the dollar to weaken and certainly it has weakened against the price of oil, against the price of precious metals and raw materials and it's lost its purchasing power. There is no question about the fact that, today, if you have $100,000 you can buy less than 10 years ago or 20 years ago. Just look at the housing market. It has come down somewhat but a house is much more expensive than in 1980.

HRN: Can you comment on inflation versus deflation?

Dr. Marc Faber: In this whole inflation and deflation debate investors have to realize that in a system—say you have a room like this and then the money is dropped from helicopters into this room, it can flow into real estate; it can flow into equities; it can flow into precious metals; it can flow into the art market or it can flow out into other currencies or into commodities that the Federal Reserve doesn’t control. They only control essentially how much money they will drop from the helicopters.

HRN: Is this an example of why central planning of the economy by the Federal Reserve isn’t effective?

Dr. Marc Faber: Yes. Exactly.

HRN: Do you think hyperinflation in the US is possible?

Dr. Marc Faber: The Federal Reserve doesn’t want to create a hyperinflation. I mean Mr. Bernanke may be incompetent, but he’s not an evil person per se. He just doesn’t have sufficient knowledge to be a central banker, in my opinion, and has misguided economic theories, but he’s not evil in the sense that he would not wish to debase the currency entirely. Clearly, if the US economy moves into a double dip recession and you have deflationary pressures reappearing, in the housing market, for example, and if the S&P drops from roughly 1,100 down to say 900, then I think further monetization will happen. I believe that because of the unfunded liabilities and the deficits of the US government, which will stay high for a long time; sooner or later there will be more monetization anyway.

It’s more a question of when it will happen rather than if it will happen. For sure it will happen but will it happen right away, say in September, or maybe only in two years time? Eventually, before everything collapses we’ll have an inflationary bout which may not be so strongly felt in consumer prices, as in stocks or housing or precious metals prices or in commodities like oil; or inflation could occur mostly in foreign currencies, in other words, in Asia where the currencies could appreciate.

HRN: Thank you for being so generous with your time.

Dr. Marc Faber: Thank you.

After Words

Dr. Marc Faber is not only one of the world’s most outspoken critics of the Federal Reserve and of its monetary policy, but is quite possibly the Federal Reserve’s most credible critic. Dr. Faber’s detailed, evidence-based arguments, linking Federal Reserve policy decisions, such as interest rate changes, to economic developments like the US housing bubble and oil price changes are supported by thorough research. Dr. Faber’s research raises serious questions about the results of central economic planning in the form of central bank monetary policy and about the wisdom of intervention into the economy by governments. The evidence suggests that centralized manipulation of money and credit has a destabilizing influence on the economy overall—it increases economic volatility—and has unintended consequences totally outside the control of so-called monetary authorities. History shows that well-intentioned lawmakers and their economic advisers cannot predict the outcomes and unintended consequences of economic interventions. Neither central bankers nor governments have been successful in substituting centrally planned economic agendas for the decentralized decisions of millions of entrepreneurs and owners of private capital, but they persist nonetheless with ever more centralized control and ever larger interventions. Dr. Faber confidently predicts that greater government control over the economy will hamper economic growth rather than stimulate it, and that interventions into the free market, no matter how large or well meaning, will continue to fail as they consistently have in the past.

Interview: Jim Rogers on Currencies and Inflation

Ron Hera — Fri, 04 Jun 2010 19:26:00 GMT

The Hera Research Newsletter (HRN) is pleased to present the following exclusive interview with legendary international investor, best selling author, adventurer and family man Jim Rogers, Chairman of Rogers Holdings and founder of the Rogers International Commodity Index (RICI). Jim Rogers’ commentaries on economics and finance have been featured in Time, The Washington Post, The New York Times, Barron’s, Forbes, Fortune, The Wall Street Journal, The Financial Times and other major publications, and he appears regularly on television networks around the world.

After growing up in Demopolis, Alabama, and earning degrees from Yale and Oxford Universities, where he studied politics, philosophy and economics, Jim Rogers co-founded the Quantum Fund in 1970, which gained 4200% over a 10-year period, during which the S&P advanced approximately 47%. After retiring at age 37, he managed his own portfolio while serving as a guest professor of finance at the Columbia University Graduate School of Business and as the moderator of WCBS’ “The Dreyfus Roundtable” and host of the Financial News Network’s (FNN) “The Profit Motive with Jim Rogers.”

Between 1990 and 1992, Jim Rogers fulfilled his lifelong dream of motorcycling across six continents in a 150,000 kilometer journey that won him a place in the Guinness Book of World Records. He also undertook a Millennium Adventure in which he traveled around the world in 1101 days, passing through 116 countries and traversing more than 245,000 kilometers.

Jim Rogers’ English language books include Investment Biker: On the Road with Jim Rogers (1994), Adventure Capitalist: The Ultimate Road Trip (2003), Hot Commodities: How Anyone Can Invest Profitably in the World's Best Market (2007), A Bull in China (2008), and A Gift to My Children: A Father's Lessons for Life and Investing (2009).

Hera Research Newsletter (HRN): Thank you for speaking with us today. Let’s start with the world reserve currency. What do you think about the International Monetary Fund (IMF) replacing the US dollar as the world reserve currency with Special Drawing Rights (SDRs)?

Jim Rogers: The world didn’t have an IMF for a few thousand years. The IMF was founded after the Second World War to take care of any short-term currency needs that countries might have. It turned out pretty quickly that they didn’t have very many as the world recovered from the war, so the IMF found other things to do. They now have thousands of employees and have manufactured jobs for themselves. They’ve not had much success, if you look back over the past 60 years. Nearly everything they’ve done was wrong. Why do we need the IMF? It’s not 1945 anymore.

HRN: Rather than using a national currency as the world reserve currency, what about a global central bank?

Jim Rogers: That’s not what the IMF is, first of all, but even if they were, we certainly don’t need a central bank for the whole world. We never had one and the world got along pretty well for thousands of years without bureaucrats taking the world’s money. I’ve never added up how much the IMF has spent during the last 60 years but it must be a staggering amount, and for what good? I mean, we certainly haven’t gotten anything out of it. We haven’t gotten nearly as much for our money as they have spent.

HRN: So, you wouldn’t agree with using IMF SDRs as the world reserve currency?

Jim Rogers: I’m sure the world does need to replace the US dollar. I’m not the only one who knows that. The US dollar is a terribly, terribly flawed currency. The US is the largest debtor nation in the history of the world. Something has got to be done. We cannot continue with a currency which is so deeply flawed and something is going to have to be changed. Special Drawing Rights, I don’t know. It could work. I don’t know what’s going to work. Most people, however, want to have something in their hands that they think they can spend. A Special Drawing Right is pretty amorphous and, while some professors and some bankers may understand them, I suspect that most people in the world will not understand Special Drawing Rights and will not be terribly enthusiastic, if that’s what happens. So, I would suspect it wouldn’t last. You know, I cannot imagine that a Special Drawing Right, which has no real existence, could survive a crisis or two. Human beings just don’t think that way, I’m afraid.

HRN: Would you advocate a commodity-backed reserve currency instead?

Jim Rogers: Reserve currencies can be anything that you want. The problem with paper money is that it’s easy to debase and abuse. As I said, the US is the largest debtor nation in the history of the world. They keep printing the stuff. The UK, once upon a time, had the world reserve currency. They abused it mightily. Eventually the world just said “no, we’re not going to take sterling anymore” and rightly so. So, in my view, that’s the problem with paper money. Now, gold has its own problems too. Gold didn’t survive very long either as the world reserve currency since politicians kept changing the rules. Unfortunately, politicians know how to abuse and destroy. One can think of various and sundry solutions. My only worry is that, no matter what mankind has come up with in the past, politicians have always found a way to abuse it and debase it.

HRN: Do you think a return to the gold standard would constrain government abuse?

Jim Rogers: Well, it never has. The Romans had precious metals as their currency and do you know the term “debase”? The Roman politicians had the brilliant idea that if a coin was 100% pure precious metal, they could slip a little base metal in and, over a couple of hundred years, they went from 100% pure precious metal to almost 0%. That’s where the term “debase” comes from. So, we’ve tried it.

HRN: You mentioned that the US is the largest debtor nation in the history of the world. Do you think that will lead to high inflation or hyperinflation in the US?

Jim Rogers: Well, there will be inflation. First, you have to have inflation before you can have hyperinflation. I mean, we have inflation now. If you go to the shop, whether it’s groceries, or education or insurance or health care, prices are going up for everything. The government lies about it in the US. Some countries lie, many countries don’t: Australia, China, India and Norway. Many countries don’t lie about it and acknowledge that we have inflation. Others lie about it, the UK and the US, but if you go shopping you know prices are up.

HRN: Are you saying that the American Consumer Price Index (CPI) published by the US Bureau of Labor Statistics is a lie?

Jim Rogers: In my opinion, yes, of course it is. Have you looked at it? They’ve changed their accounting several times in the past few decades. When housing was 20% to 25% of the CPI and housing was going up, they didn’t count it, saying rents weren’t going up, and then when home prices started going down, they counted it. It’s the same with many things. It’s staggering some of the tortuous reasoning that the BLS has used over the past 25 or 30 years. When the price of gasoline goes up, they say it’s not really going up because it’s better gasoline, better quality, therefore you’re getting more for your money. I mean, it’s endless, the stuff that they say and for some reason people sit there, although more and more people are catching on, and accept what the government says. As I said, in other countries, they acknowledge that there’s inflation. I don’t know how there could be inflation in Australia and not in the US; how you can have inflation in Norway or India and not in the US, but the US says there’s no inflation.

HRN: An article in the Telegraph by Ambrose Evans-Pritchard reported this week that the US Federal Reserve’s M3 monetary aggregate is estimated to be contracting at an accelerating rate, in other words, deflation.

Jim Rogers: What’s going down in price in the US economy? I’d like to know where you shop. We know home prices are down. Oil prices are down to $73 per barrel, if you’re talking about a monthly or quarterly basis, or even an annual basis. I’m talking about what’s going on in the big picture. Where is the deflation in the US?

HRN: Some people believe a contraction of M3 indicates deflation.

Jim Rogers: Is M3 something you buy in a shop? M3 can lead to changes in the price structure, but M3 is not price inflation or deflation.

HRN: That’s a good point. Inflation is a concern in Europe and the Euro seems to be in trouble. Can the Euro survive?

Jim Rogers: I certainly expect the Euro to be around in 2012 or 2013, but whether it’ll be around in 2023, I don’t know. It’s becoming more and more a political currency. It wasn’t always. In the beginning, it wasn’t a political currency. It was designed to be a rock solid currency, but, since then, it’s become a political currency and most political agreements or political institutions don’t last. No currency union has ever lasted. It’s been tried before. I wish the Euro would survive. The world needs something to compete with the dollar. The Euro, on paper, makes enormous sense, but, unfortunately, the people who wrote that contract back in 1992 are all gone now and the new guys all want to buy votes. So, I would like to see the Euro survive, but, in reality, I don’t see how it can.

HRN: So, you expect more inflation in Europe?

Jim Rogers: Yes. Printing money has always led to inflation, eventually. When things go wrong, governments have always printed money, at least in the last few decades. That’s all they know and they will do it again. There will be times, obviously, when the printing presses slow down or even stop but when things get bad again they start over, and that’s all they know.

HRN: I’ve read that China is experiencing high inflation.

Jim Rogers: There is inflation in China. There are many places that are reporting inflation. It’s dumbfounding to me that many countries have inflation and the US doesn’t. That’s because some governments lie and some governments don’t.

HRN: It’s been widely reported that Chinese real estate is in a bubble. Do you think that’s true?

Jim Rogers: In urban, coastal real estate there certainly was a bubble. That’s not the whole of China. Have you ever looked at a map of China? Do you consider urban, coastal real estate the Chinese economy? Where’s the bubble? Other real estate in China has, for the most part, had very little movement.

HRN: Do you think China’s economic growth is sustainable?

Jim Rogers: Is it sustainable, yes; every quarter, every year, of course not. You know, in the United States in the 19^th century, we had 15 depressions, a horrible civil war, no human rights, massacres in the streets and very little rule of law, and yet, out of that, we had a pretty successful 20^th century. China is going to have many, many problems as they rise. I don’t know what and I don’t know when, but I know it’s going to happen. I don’t see any other country on the horizon that is going to have, long term, a sustainable, good future in the 21^st century.

HRN: You’ve talked about inflation, pointed out problems with the US dollar and the Euro, and described the rise of China. How can citizens of Western countries protect their wealth?

Jim Rogers: Historically, the best way is to own commodities. Throughout history, the way you protect yourself when currencies are being debased is that you own real goods. Whether that’s silver or cotton or natural gas or whatever it happens to be, you own something that’s a real good. As the value of money is debased, some things will maintain their value and some will even increase.

HRN: Investors seem to be turning to gold as a way to preserve their wealth.

Jim Rogers: Gold has been, historically, a good way to preserve wealth, but so have other things as well. I own gold. Gold is making all-time highs. It certainly has been a way to preserve wealth in the last decade. Whether there are better things in the next decade or not, and I suspect that there will be better things, I do own gold.

HRN: You mentioned silver as a way to preserve wealth but gold seems to be in the spotlight.

Jim Rogers: Let’s put it this way, silver is about 70% below its all-time high. Gold is making all-time highs. Often, one is better off investing in things that are down 70%, rather than things that are making all-time highs.

HRN: Thank you for being so generous with your valuable time.

Jim Rogers: Thank you very much. Contact me any time.

After Words

Jim Rogers doesn’t mince words. When a person as remarkably successful and accomplished as Jim Rogers, and having long experience, states that the official statistics produced by government economists and views expressed in mainstream financial news outlets are incorrect, or disingenuous, one must take pause. Objectively speaking, for a majority of investors, views that are at odds with those of Jim Rogers are probably wrong.

According to Jim Rogers, the US dollar is deeply flawed because the US is the biggest debtor nation in the history of the world and, although an alternative currency is needed, the Euro will not survive in the long run because it has become political and IMF SDRs will probably not last as a reserve currency in the face of significant global economic crises. Long-term trends point to inflation and to the sustainability of China’s economic growth, as well as to China’s ascent as a world power. As prices inevitably, eventually rise due to inflation, real goods stand out as a time tested way to preserve wealth and to profit from changing economic conditions. In simple terms, currencies can be printed but real things cannot.

Into the Abyss: The Cycle of Debt Deflation

Ron Hera — Wed, 02 Jun 2010 12:46:00 GMT

One of the most famous quotations of Austrian economist Ludwig von Mises is that “There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion or later as a final and total catastrophe of the currency involved.” In fact, the US economy is in a downward spiral of debt deflation despite the bold actions of the federal government and of the US Federal Reserve taken in response to the financial crisis that began in 2008 and the associated recession. Although the vicious circle of debt deflation is not widely recognized, precisely what von Mises described is happening before our eyes.

A variety of positive economic data has been reported in recent months. Retail sales rose 0.4% in April 2010 as consumer spending rose and the US gross domestic product (GDP) grew at a rate of 3%. In May 2010, home sales rose to a five-month high and consumer confidence rose 17% (from 57.7 to 63.3). Industrial production rose 0.8% and durable goods orders rose 2.9%, more than had been forecast. However, the modest gains reported represent the continuing adaptation of economic activity at dramatically lower levels compared to the pre-recession period and most of the reported gains have been substantially manufactured by massive government deficit spending.

Despite the widely reported green shoots, in May, the unemployment rate rose to 9.9% while paychecks in the private sector shrank to historic lows as a percentage of personal income, and personal bankruptcies rose. Roughly 14% of US mortgages are delinquent or in foreclosure, credit card defaults are rising and consumer spending hit 7 month lows. To make matters worse, the reported increase in consumer credit, in fact, points to a further deterioration because consumers appear to be borrowing to service existing debt. Outside of the federal government, which is borrowing at record levels and expanding as a percentage of GDP, and outside of the bailed out financial sector, debt deflation has continued unabated since 2008.

Money Supply vs. Debt Service

A contraction of the broad money supply is taking place because the influx of money into the US economy, i.e., lending to consumers and non financial businesses, has fallen below the rate at which money is flowing out of general circulation as a function of debt service (interest and principle payments on existing debt), thus a net drain of money from the broad US economy is taking place. As a result, additional borrowing, as consumer spending falls, appears to be servicing existing debt in a pattern that is clearly unsustainable and that signals a further rise in debt defaults in coming months.

^{Chart courtesy of}^{Shadow Government Statistics}

The estimate of the broad money supply (the Federal Reserve’s M3 monetary aggregate) is crashing and the Federal Reserve’s M1 Money Multiplier, a measure of how much new money is created through lending activity, fell off of a cliff in 2008, and remains practically flat-lined.

^{Chart courtesy of the}^{Federal Reserve Bank of St. Louis}

The contraction of the broad money supply points to a potential slowing of economic activity and indicates that consumers and non financial businesses will be less able to service existing debt. Despite easing somewhat in March 2010, credit card losses are expected to remain near 10% over the next year and mortgage delinquencies, are currently at a record highs, and these dismal predictions implicitly assume a stable or growing money supply.

A tsunami of eventual mortgage defaults seems to be building and loan modifications have been a failure thus far. There have been only a small number of permanent loan modifications (295,348) under the Home Affordable Modification Program (HAMP) in 2009, out of 3.3 million eligible (60 days delinquent) loans and more than half of modified loans default.

^{Chart courtesy of}^{Calculated Risk}

Although it has been reported that American consumers are saving at a rate of 3.4%, the contraction of the broad money supply suggests savings liquidation. Given a contracting money supply, ongoing debt defaults and declining consumer spending, the increase in non-mortgage consumer loans indicates that consumers are borrowing where possible to consolidate debts, cover debt service, or borrowing to continue operating financially as their total debt grows, thus as they approach insolvency.

^{Chart courtesy of the}^{Federal Reserve Bank of St. Louis}

The increase in non-mortgage consumer loans has not prevented an overall decline in total household debt attributed to ongoing deleveraging by consumers. While deleveraging (paying down debt) has been interpreted as caution on the part of consumers, or as low consumer confidence, the decline in outstanding credit reflects a reduced ability to borrow, i.e., to service additional debt. This suggests that the recovery of the US economy may be illusory and that the economy is likely to contract further in coming months.

^{Chart courtesy of the}^{Federal Reserve Bank of St. Louis}

Commercial borrowing has declined more sharply than household debt suggesting that the nominal return to growth estimated at 3% has not been matched by debt financed expansion in the private sector.

^{Chart courtesy of the}^{Federal Reserve Bank of St. Louis}

The broad US money supply is no longer being maintained or expanded by normal lending activity. If federal government deficit spending ($1.5 trillion annually), debt monetization and emergency actions by the Federal Reserve (totaling an estimated $1.5 trillion since 2008) to recapitalize banks are considered separately, there remains a net drain effect on the broad money supply. The scarcity of money hampers economic activity, i.e., money is less available for investment, and directly exacerbates debt defaults as consumers and businesses experience cash shortfalls, while at the same time being less able to borrow. Since unemployment is a key indicator of recession, then if the US economy were contracting, it would be evident in unemployment statistics.

Structural Unemployment

Unemployment and labor force data suggest that the US labor market is in a structural decline, i.e., millions of jobs have been and are being permanently eliminated, perhaps as a long term consequence of offshoring, outsourcing to other countries and the ongoing deindustrialization of the United States. However, the immediate meaning of the term “structural” has to with the fact that jobs created or sustained during the unprecedented expansion of debt leading to the financial crisis that began in 2008, e.g., a substantial portion of service sector jobs created in the past two decades now appear not to be viable outside of a credit expansion.

Officially, the US unemployment rate rose to 9.9% in April 2010, which represents the percentage of workers claiming unemployment benefits. However, the total number of unemployed or underemployed persons, including so-called “discouraged workers” (Bureau of Labor Statistics U-6), rose to 17.1%. Using the same methods that the BLS had used prior to the Clinton administration, U-6 would be approximately 22%, rather than the official 17.1% statistic.

^{Chart courtesy of}^{Shadow Government Statistics}

With official U-6 unemployment of 17.1% and a workforce of 154.1 million there are roughly 26,197,000 people officially out of work. Using the pre-Clinton U-6 unemployment calculation of approximately 22%, there would be 33.9 million unemployed. If the average US household consists of 2.6 persons and if 33% of the unemployed are sole wage earners, then 55.5 million US citizens currently have no means of financial support (17.9% of the population).

^{Chart courtesy of}^{Calculated Risk}

While it has been reported that the labor force is shrinking, the characterization of workers permanently exiting the workforce by choice may be inaccurate. While a shrinking workforce could reflect demographic changes, the rate of change suggests that tens of millions of Americans are simply unemployed.

^{Chart courtesy of the}^{Federal Reserve Bank of St. Louis}

Setting aside the question of whether or not those “not in the workforce” are, in fact, permanently unemployed, the workforce, as a percentage of the total US population, is currently at 1970s levels. Since many more households today depend on two incomes to meet their obligations, compared to the 1970s, a marked drop in the percentage of the population in the workforce points to a decline in the labor market more significant than official unemployment statistics suggest. What is more important, however, is that structural unemployment suggests structural government deficits, e.g., unemployment benefits, welfare, food stamps, etc. Since more than 2/3 of US GDP (roughly 70%) consists of consumer spending, a sustainable recovery from recession seems improbable if unemployment is worsening or if the labor force is in a structural decline, since that would imply unsustainable government deficits, whether or not they are masked by nominal GDP gains thanks to economic stimulus measures.

Government and GDP Growth

The US federal government is a growing portion of GDP, thus reported GDP growth is largely a byproduct of government deficit spending and stimulus measures, i.e., reported GDP growth is unsustainable. Total government spending at the local, state and federal levels accounts for as much as 45% of GDP, thus nominal gains would be expected when government deficit spending increases. According to some measures, reported gains in GDP are a byproduct of relatively new statistical methods and, using earlier methods of calculation, GDP remains negative.

^{Chart courtesy of}^{Shadow Government Statistics}

Government borrowing and spending may have offset declines in the private sector but only to a degree and only temporarily. The resulting growth in US public debt has an eventual mathematical limit: insolvency. Of course, the actual limit to US borrowing remains unknown. The continuing solvency of the US depends on the ability and willingness of governments, banks and investors around the world to lend to the US, which in turn depends on the tolerance of lenders for the US government’s profligacy and money printing by the Federal Reserve, e.g., quantitative easing and exchanging new cash for worthless bank assets. US Treasury bond auctions will fail if lenders conclude that a sufficiently large portion of their investment will be diluted into oblivion by proverbial money printing. In that event, the US dollar will surely plummet, despite deflationary pressures within the domestic US economy, and the cost of foreign goods, e.g., oil, will rise causing high inflation or triggering hyperinflation.

^{Chart courtesy of the}^{Federal Reserve Bank of St. Louis}

According to the Bank for International Settlements (BIS), the federal budget deficit increased from 3.1% of GDP in 2007 to 9.2% in 2010. Rather than being the result of one-time expenses, such as temporary stimulus measures, much of the deficit represents permanent increases in government spending, e.g., due to the growing number of federal employees. If increased government spending is removed, GDP appears to be declining significantly.

^{Chart courtesy of}^{Karl Denninger}

Of course, sustainability has more to do with total debt than with deficit spending because a deficit assumes that there is an underlying capacity to service additional debt.

Unsustainable Debt

While asset prices have declined, e.g., real estate and equities, debt levels have remained high due to the federal government’s policy of preserving bank balance sheets, which had ballooned prior to the financial crisis to the point that overall debt in the US economy reached unsustainable levels.

^{Chart courtesy of}^{Karl Denninger}

The absolute debt to GDP ratio of the US economy peaked in 2007 when debt levels exceeded the ability of the economy to service debt from income based on production, even at low interest rates. Although US GDP began to decline prior to the advent of the global financial crisis, debt coverage had been in decline approximately since the 1970s, coincidentally, around the time that the US dollar was decoupled from gold.

^{Chart courtesy of}^{Karl Denninger}

Government deficit spending cannot correct the situation because, for every dollar of new borrowing, the gain in GDP is negligible and some have argued that the US economy has passed the point of “debt saturation.”

^{Chart courtesy of}^{Nathan A. Martin}

In a growing economy, additional debt can result in a net gain in GDP because the money supply grows and economic activity is stimulated by transactions that flow through the economy as a result. The debt saturation hypothesis is that, as debt levels rise, additional debt has less impact on GDP until a point is reached where new debt causes GDP to decline, i.e., the capacity of the economy to service debt has been exceeded and, not only is it impossible for the economy to grow at a rate sufficient to service existing debt (since interest compounds), but economic activity actually declines further as a function of additional debt.

A Downward Spiral

The process of debt deflation is straightforward. New lending at levels that would maintain or expand the broad money supply is impossible for two reasons: (1) asset values and incomes have fallen and millions remain unemployed; and (2) debt levels remain excessive compared to GDP, i.e., real economic activity (outside of the government and financial services industry) cannot service additional debt. The inability to lend, actually the result of prior excess lending, results in a net drain of money from the economy. The drain effect, in turn, leads to further defaults as cash strapped consumers and businesses fail to service existing debt, and as debt defaults impact bank balance sheets, putting a damper on new lending and completing the cycle of debt deflation.

Keynesian economic policies, i.e., government deficit spending, are irrelevant vis-à-vis excessive debt levels in the economy and bailing out banks is not a solution since it cannot stop the deterioration of their balance sheets. The process is self-perpetuating and cannot be stopped by any government or monetary policy because it is not a matter of policy, but rather one of mathematics.

Since the presence of excess debt (beyond what can be supported by a stable GDP, or by sustainable GDP growth) impacts the broad money supply, efforts to preserve bank balance sheets, i.e., to keep otherwise bad loans on the books of banks at full value, will ultimately cause bank balance sheets to deteriorate more than they would have otherwise. The fact that US banks issued trillions in bad loans cannot be corrected by changing accounting rules, nor can the consequences be avoided by government deficit spending or by unlimited bailouts, and the problem cannot be papered over by dropping freshly printed money from helicopters flying over Wall Street. The major problems facing the US economy today—a tsunami or debt defaults, structural unemployment, massive government budget deficits, a contraction of the broad money supply outside of the federal government and the financial system, and a lack of sustainable growth—cannot be addressed as long as excess debt levels are maintained. As von Mises clearly understood, sound economic conditions cannot be restored unless and until the excess debt, which resulted from a boom brought about by credit expansion, is purged from the system. The alternative, and the current policy of the United States, is a downward spiral into a bottomless economic abyss.

Bernanke’s Dilemma: Hyperinflation and the US Dollar

Ron Hera — Wed, 10 Mar 2010 13:13:00 GMT

Ben Bernanke, Chairman of the US Federal Reserve, faces a Sisyphean task because US banks are experiencing debt deflation and, because lending is now at much lower levels, monetary deflation is encumbering the domestic US economy as existing debts continue to be serviced. Government deficit spending can only offset lower consumer spending to a degree, and the mushrooming debt of the US government raises the question of whether the US can repay or roll over its debt obligations, given that tax receipts are likely to fall. Despite deflationary pressure, the value of the US dollar is in a downtrend pointing to higher prices for imported goods and energy. Devaluing the US dollar will reduce the value of debts in real terms, thus it can make debt levels sustainable, but higher prices will exacerbate debt defaults, worsening the condition of US banks. Mr. Bernanke's dilemma is how to salvage the balance sheets of US banks without sparking high inflation or unleashing hyperinflation.

Where the US dollar is concerned, opinions on hyperinflation range from the view that hyperinflation of the world reserve currency is impossible in principle (because, for example, the values of other currencies are linked to that of the US dollar), to the view that hyperinflation of the US dollar has already happened and that all that remains are the consequences. The two most widely accepted theories of hyperinflation are the monetary model, where a positive feedback cycle is caused by a disproportionate increase in the velocity of money as a consequence of increasing the money supply too quickly, and the confidence model, where the monetary authority issuing a given currency is perceived to be insolvent or no longer legitimate.

The view that hyperinflation is the inevitable result of a central bank issuing too much money or of a government taking on too much debt, while correct, both states the obvious and presupposes that some previously known or predictable limit is reached. The ability to service debt is one such measure, but the value of a debt in real terms depends on the value of the currency. In practice, hyperinflation is recognized only after the inexorable death spiral of a currency has begun. Detecting it in advance is another matter entirely.

Mathematical models of hyperinflation, such as predicting years between redenomination based on inflation rates or applying the quantity theory of money, describe what is happening but not why. Using the monetary model alone makes it difficult to explain apparent counterexamples where high levels of sovereign debt compared to a nation's gross domestic product (GDP) or monetization did not result in hyperinflation.

The confidence model seems to suggest that hyperinflation can be explained by crowd psychology where hyperinflation is analogous to a market mania or is an example of mass hysteria. The idea that hyperinflation is only a crisis of confidence, i.e., that it is a psychological phenomenon, not only lacks predictive value but implies that hyperinflation can be prevented by manipulating public opinion regardless of mathematical realities.

When a nation's bond market collapses, so does its currency. The view that hyperinflation is fundamentally caused by failed bond issues suggests that what is of interest are the reasons why a nation's bond market breaks down, along with indications of developing bond market distress.

One fact that is clear in every historical example of hyperinflation is the rejection of the currency of a given country either by other countries or by its own citizens. The simplest explanation of hyperinflation is that when the credibility of a government, or of its central bank, breaks down, the recognition of this fact is expressed as a race to shed the currency and to divest of the government's bonds. One way to evaluate the possibility of hyperinflation is therefore to gauge the transparency, completeness and veracity of government and central bank statements regarding their balance sheets, budgets and bond issues. Incomplete or inaccurate information and propaganda contrary to empirical evidence are proverbial red flags signaling that credibility may be lacking and that confidence is therefore misplaced.

Between Scylla and Charybdis

Growth in the US monetary base has been cited as evidence of incipient hyperinflation but, while a distortion in the US financial system is apparent, the currency in question is not in circulation and the effect is that of re-inflation since US banks have suffered massive losses linked to the US mortgage market.

Chart courtesy of Federal Reserve Bank of St. Louis

The growth in the US monetary base by over $1 trillion since 2008 represents currency held within the banking system on reserve, which increases the ability of US banks to absorb further losses.

Chart courtesy of Federal Reserve Bank of St. Louis

While more than doubling the US dollar monetary base in less than 2 years is viewed by some as printing too much money, high inflation or hyperinflation have yet to strike. Although money has shifted out of the broad US economy and into the banking system, the excess liquidity exists in the form of bank reserves and, despite the fact that inflation is always and everywhere a monetary phenomenon, if bank reserves are considered separately from interest rates and lending activity they have little direct impact on prices in the broad US economy. In fact, the widest measure of the US money supply is contracting and the broad US economy is in the grip of debt and monetary deflation.

Chart courtesy of Shadow Government Statistic

In terms of monetary policy, Mr. Bernanke faces an impossible choice. With interest rates near 0% and with unprecedented government debt and deficit spending beyond sustainable levels there is a clear risk of high inflation or hyperinflation if inflationary forces are not counterbalanced with a heavy hand. In theory, high inflation or hyperinflation could be prevented by restricting the flow of money and credit to consumers and businesses. Such a policy would exert deflationary pressure on the US dollar within the domestic US economy since principal and interest payments on existing debt would drain money from circulation. While preventing inflation temporarily, such a policy would not succeed in the long run because, in addition to offsetting inflation, deflation depresses economic activity and results in debt defaults. Concurrent government borrowing and central bank QE to recapitalize banks and sustain government deficit spending (in a Keynesian attempt to compensate for declining consumer and business borrowing), would cause the value of the US dollar to decline against other currencies thus the prices of imported goods would rise. The resulting combination of rising prices for imported goods (energy in particular) and a scarcity of money in the domestic US economy is a formula for business failures and debt defaults that would ultimately worsen the condition of the US economy and US banks regardless of lower prices for domestic goods and services.

Structural Decay

In a mathematically perfect world, growth in the money supply with a constant interest rate and level of lending is a simple exponential function. In theory, this is not problematic but in practice monetary expansion (and the associated debt) tends to grow faster than population or sustainable economic activity and even periodic deflationary episodes are insufficient to maintain a stable currency value.

Chart courtesy of Wikimedia Commons

The tendency to create currency in excess of what is required to support sustainable economic activity causes unsustainable booms where debt rises out of proportion to the ability to service or eventually repay, meaning that total debt in the economy grows faster than the GDP. The result is that for every boom artificially created by monetary expansion there is a corresponding episode of debt and monetary deflation. Nonetheless, the overall pattern of monetary expansion remains clear.

Chart courtesy of Federal Reserve Bank of St. Louis

From a policy standpoint, restraining debt issuance by private, profit-oriented banks to sustainable levels is impossible in practice because sustainable growth in GDP is an unknown when the interest rates and reserve ratios that moderate lending activity are set. In fact, the goals of the US Federal Reserve, "to promote ... stable prices and moderate long-term interest rates" require the money supply to expand faster than sustainable economic activity:

Sometimes, however, upward pressures on prices are developing as output and employment are softening-especially when an adverse supply shock, such as a spike in energy prices, has occurred. Then, an attempt to restrain inflation pressures would compound the weakness in the economy, or an attempt to reverse employment losses would aggravate inflation. In such circumstances, those responsible for monetary policy face a dilemma and must decide whether to focus on defusing price pressures or on cushioning the loss of employment and output. Adding to the difficulty is the possibility that an expectation of increasing inflation might get built into decisions about prices and wages, thereby adding to inflation inertia and making it more difficult to achieve price stability.

Deflation is anathema because debt defaults harm lenders and governments have no mechanism to tax gains in the value of currency, thus monetary policy always errs toward inflation and over time the result approximates an exponential function. Among the results is the long term devaluation of the currency, which can also be expressed as an exponential function, i.e., exponential decay.

Chart courtesy of Wikimedia Commons

Exponential decay occurs when a quantity, such as the value of a unit of currency, decreases at a rate proportional to its own value. The decay can be expressed as a differential equation where a quantity N decays at a constant rate (a positive number) (lambda) within a given interval of time t.

Central banks implicitly manage the exponential decay in value of their respective currencies while they focus on interest rates, reserve ratios and inflation targets. Although the exponential decay in the value of the US dollar since 1913 has been distorted by episodes of deflation and variations in monetary policy, the overall pattern continues to reflect the structural reality of exponential decay.

Chart courtesy of Federal Reserve Bank of St. Loui

The combination of fiat currency, where currency is created arbitrarily, and central banking, where money and credit are centrally controlled and where there is an inescapable inflationary bias, suggests that all such regimes have a limited lifespan, but this does not allow a hyperinflationary outcome to be predicted. For example, if US citizens had been asked in 1913, when the Federal Reserve was established, if they would use the Federal Reserve's legal tender knowing that $1 would be roughly $0.05 in less than 100 years they would certainly have responded in the negative, but Federal Reserve Notes have not been rejected by the American people. Similarly, there is no necessary or obvious point where the US dollar will be rejected as it continues to decline in value for the same structural reasons. The logical outcome is an eventual redenomination.

Patterns of Hyperinflation

From the perspective of sovereign debt, the commonly understood process of hyperinflation is that if a government responds to declining foreign appetite for its debt with monetization (or in a historical context direct currency debasement) rather than immediate budget cuts, its currency looses value, at first in proportion to the dilution of the money supply and then more quickly as foreign bond holders and the nation's own citizens seek shelter from inflation in other asset classes. The cost of the government's future obligations then tends to rise in nominal terms, creating an apparent need for larger bond issues while bond yields rise, i.e., the cost of borrowing increases since monetization signals greater risk to investors. Exacerbating the problem, tax receipts tend to lag behind as domestic price inflation sets in. Further monetization is the path of least resistance. Although officials certainly believe that monetization is only a temporary measure both confidence in and the credibility of the government fail. Insolvency is eventually recognized as a reality and the nation's currency then collapses entirely.

Economists assume that consumers and businesses respond predictably based on economic incentives and disincentives, but this presupposes that the value of money is stable (at least over the short term). If users of a currency find that it looses value such that savings and wages are perceptibly eroded before they can be utilized at fair value, the rational course of action is to shed the currency as quickly as possible. This sparks a competition to shed currency in favor of real goods and, once the process begins, the rational course of action is to participate in the proverbial rush to the exits. Interestingly, a panic is not required to explain this phenomenon.

In the context of a national economy, the cycle of hyperinflation is driven not precisely by the supply of money but by its velocity because the competition to shed currency concentrates purchasing activity in successively shorter time periods. Within a given interval, more consumers and businesses seek to buy a limited supply of available goods using all available currency, including savings, thus demand is pulled forward while the velocity of money accelerates. If monetary authorities respond by increasing the money supply, the process feeds on itself.

In terms of the quantity theory of money, which is that the money supply has a direct, positive relationship to prices, the equilibrium of prices with the number of items purchased and the money supply with the velocity of money is maintained (where M is the money supply, V is the velocity of money, P is the average price level, and Q is the number of items purchased over a given interval).

The relation holds true even as the value of a currency approaches zero while prices approach infinity. However, while there is no theoretical limit to the money supply, the supply of goods is limited in various ways and shortages of goods spur prices higher, exacerbating the problem.

The competition to shed currency first interacts with prices then with the availability of currency and with the supply of goods. Rising prices result in rising demand for larger amounts and denominations of currency producing a genuine shortage, but increasing the money supply only intensifies the competition to shed currency, like pouring gasoline on a fire.

Crisis of Credibility

A gradual decline in the value of a currency is generally accepted by consumers and businesses because it has little immediate impact and can have short-term benefits, such as making money more accessible and stimulating economic activity and growth. However, when debt increases disproportionately, a deflationary bust is inevitable and if it is postponed by further credit expansion systemic instability results.

Chart courtesy of Karl Denninger

In 1949 Ludwig von Mises pointed out in Human Action (Chapter XX, section 8) that "there is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved."

Among other things, excessive monetary inflation means that the US dollar cannot function as a store of value. Mounting evidence points to systemic instability, a lower US dollar and ultimately to a hyperinflationary outcome:

US federal government debt of $12.3 trillion, unfunded liabilities of $63 trillion, deficit spending of $1.35 trillion for fiscal 2010, and the Obama administration's $3.83 trillion budget all set new records, while federal income tax revenues are expected to fall for a second consecutive year.
It has been reported that to reduce the cost of borrowing, the maturity of debt issued by the US Department of the Treasury has shifted from the long end of the spectrum toward short term debt. At the same time, episodic flights to the perceived safety of the US dollar by global investors favor short-term Treasuries. This situation creates an escalating risk that the US Treasury will be unable to roll over short term debt and that it will resort to monetization.
7 US states are worse off than the financially troubled European nations of Greece, Ireland, Portugal and Spain resulting in warnings of a US credit rating downgrade possibly indicating an eventual sovereign default.
Unemployment in the US, where more than 2/3 of GDP is consumer spending, should be viewed as a leading, rather than a trailing indicator, thus the perception of recovery based on slowing unemployment is premature. Reported unemployment data seem to exhibit unusually pronounced disparities between initial claims and later revisions and seasonally adjusted numbers.
The widely reported recovery of the US economy is anemic at best since most of the reported forth quarter 2009 GDP growth is not sustainable and preliminary government economic data remains subject to revision by the US Bureau of Economic Analysis (BEA).
The imminent retirement of the so-called baby boomer generation comes with a combined Social Security and Medicare price tag of more than $60 trillion.
US bank failures and balance sheet deterioration together with the inability of banks to mark assets to market due to a growing commercial real estate problem and ongoing residential mortgage loan problems suggest that the financial crisis that began in 2008 is not over.
The suspension of the US Financial Accounting Standards Board's mark to market rule means that the value of mortgage loan portfolios and mortgage-backed securities (MBS) reported by banks are incorrect, which obfuscates leverage and risk while magnifying apparent profits.
Toxic assets still cripple bank balance sheets since the US Department of the Treasury has been unable to successfully carry out its Public-Private Investment Program (PPIP) making taxpayer money available to select investors that can use the money to buy toxic mortgage-backed securities, retaining any profits while putting little of their own money at risk.
The largest US Banks remain the largest holders of financial derivatives, e.g., credit default swaps (CDSs), which suggests that they may hold liabilities far in excess of amounts that can be paid or that can be bailed out if significant losses occur. The CDS market, which is the single largest class of financial derivatives, represents over $600 trillion dollars, a roughly 10x multiple of world GDP.
The Federal Reserve's plans to phase out some of its emergency programs, adding up to roughly $2 trillion currently, leaves other emergency measures in place. The Term Asset-backed Securities Loan Facility (TALF) is set to expire on June 30, 2010 for loans backed by new-issue commercial mortgage-backed securities and on March 31 for loans backed by all other types of collateral but existing loans will not be retired for some time.
Downward pressure on the US dollar caused by the Federal Reserve's near 0% interest rates and ongoing QE has caused a US dollar carry trade affecting asset prices in global markets. While the value of the US dollar has rallied in response to episodic flights to perceived safety in US Treasuries reflecting comparative weakness in the Euro and other currencies, the overall downtrend is persistent, thus the prices of imported goods can be expected to rise.

Rather than a crisis of confidence, hyperinflation results from a crisis of credibility. Hyperinflation results when the social, legal and political structures that create the value of paper money break down. When a government borrows excessively and its promises to repay are contradicted by mathematical realities, the value of its currency cannot be maintained. If a government so lacks credibility that it cannot issue bonds because there are no buyers other than its own central bank, the value of its currency declines faster than money is printed to cover its obligations. Perhaps the most important indicator of impending hyperinflation is whether the statements of a government or of its central bank, e.g., with respect to the government's budget or the central bank's balance sheet, are evidence based or ideological. If they are not evidence based, the credibility of the government or central bank, and its currency, will weaken and eventually fail.

Ordinarily, supply and demand factors govern the value of money and the prices of goods, but money has another, deeper level of value apart from its role as a medium of exchange and unit of account. When money is not redeemable, it is, in effect, a contract and, as such, it can instantly become more worthless than the paper it is printed on if the agreement that gives it value is null and void.

In 1999, referring to the sale of British gold reserves, Alan Greenspan, then Chairman of the US Federal Reserve, said that "Fiat money paper in extremis is accepted by nobody." The reason for this is that there are two fundamental kinds of value. De jure value exists because of, and is dependent upon, social, political and legal arrangements between human beings. In extremis, agreements are often broken and unenforceable. The value of fiat currency and of government bonds are examples of de jure value. Ultimately, de jure value actually exists only in the minds of human beings and does not exist in an absolute sense, in the real world, independent of human belief. De facto value, on the other hand, exists in reality, independent of human thought, e.g., lumber or farmland. The value of real, tangible things of value ultimately devolves to biological survival and to material standards of living. Possessing a physical asset that supports survival does not require human belief in order to have biological value.

When social, political and legal arrangements are strong, reliable and endure over generations de jure value may be preferable for any number of reasons. However, when social, political and legal arrangements prove to be unstable, or fail, de facto value trumps de jure value in every case.

When the balance sheets of US banks are maintained by suspending accounting rules and when banks hold financial derivatives liabilities greater than world GDP, both the stability and credibility of the banks are questionable. When US economic data consistently seems to reflect a Pollyanna bias and the US federal budget contains unrealistic projections of GDP growth and tax revenues, while public debt and government liabilities (which now include unlimited bailouts for government sponsored entities Fannie Mae and Freddie Mac) are obviously unworkable and the US government's own central bank is already a major buyer of US Treasuries, the federal government's credibility is questionable. When private financial losses and toxic financial assets are transferred to taxpayers while profits and bonuses abound on Wall Street thanks to accounting rule changes in the midst of the worst economic contraction since the Great Depression, the credibility and competency of the US Treasury and Congress, with respect to the finances of the nation, are questionable. When the US Federal Reserve defies the US Congress, resists independent auditing, engages in ongoing QE and is the lender of last resort for banks that under normal conditions would be insolvent, its credibility is questionable. When the Chairman of the Federal Reserve, who failed to detect the largest asset price bubble in the history of the world and who has been consistently wrong in his assessment of the US economy is reappointed following the worst financial and economic disaster in generations, both his credibility and that of the Obama administration are questionable. The plethora of red flags spewing from Wall Street, from the Federal Reserve and from the federal government point to a breakdown of de jure value that is already in progress, thus to a hyperinflationary outcome for the US dollar.

The Ultimate Bubble and the Mother of All Carry Trades

Ron Hera — Sun, 31 Jan 2010 15:14:00 GMT

Among the many opinions expressed by billionaire investor George Soros over the course of the 2010 World Economic Forum in Davos, Switzerland was his statement on January 28 in an interview with Maria Bartiromo, host of CNBC's Closing Bell, that "When interest rates are low we have conditions for asset bubbles to develop, and they are developing at the moment. The ultimate asset bubble is gold." New York spot gold closed at $1085.40 down $1.80, but the price of gold is not as much about gold as it is about the value of currencies, particularly the US dollar.

Since new currency is created through lending activity, very low or 0% US interest rates and government deficit spending are fueling a US dollar carry trade and monetary inflation in the US dollar resulting in rising asset prices and global speculation. According to Zhu Min, deputy governor of the People’s Bank of China, “[The US dollar carry trade] is a massive issue; estimates are that it is $1.5 trillion, which is much bigger than Japan’s carry trade.” The close relationship of global commodity prices, particularly the gold price, to the value of the US dollar can be seen by comparing the changing value of the US Dollar Index to an inverted US dollar spot gold price chart.

^{Chart courtesy of}^{StockCharts.com}

The inverted gold price chart follows the USDX closely and while the fluctuations are not strictly proportional the overall trends as well as the peaks and troughs generally correspond, thus the asset price bubbles noted by Mr. Soros are reflections in asset prices of both the US dollar carry trade (the effective value of the US dollar) and, ultimately, of the long-term devaluation of the US dollar, thus the value of the US dollar in real terms.

^{Chart courtesy of}^{StockCharts.com}

An “ultimate bubble” in gold could be an offspring of the mother of all carry trades, but its magnitude would depend not only on the effective value and rate of change in value of the US dollar while the carry trade is booming, but also on the actual, eventual value of the US dollar (in real terms) after the carry trade has come to an end. Although the value of the US dollar will certainly recover to some degree when the carry trade ends, it will remain significantly lower in value for other reasons.

US Dollar Devaluation

In the above mentioned interview, Mr. Soros went on to say that "Some countries, like the US and European countries have plenty of room to increase their deficits; [although] the political resistance to doing so increases the chances of a double dip [recession] in the [global] economy in 2011 and after that." Since further monetary inflation as a consequence of government deficit spending may be necessary to maintain economic stimulus measures and financial system life support, Mr. Soros anticipates further devaluation of the US dollar. Devaluation of the US dollar will have both beneficial and harmful effects on the US economy.

Devaluation of the US dollar will reduce the value of debts in real terms, reducing the overall debt to GDP ratio of the US economy, and stimulate nominal GDP growth as domestic prices and wages (at different rates) adjust to the altered value of the US dollar, while at the same time helping to create conditions where US banks can resume lending to consumers and small businesses. Unfortunately, currency devaluation also has deleterious effects, such as higher prices, a loss in the value of savings and a reduction in the real value of wages. There is also a risk of uncontrolled domestic price inflation (although prices can be held in check without raising interest rates by curtailing the flow of money and credit to consumers and small businesses).

^{Chart courtesy of}^{Karl Denninger}

In addition to reducing the US debt to GDP ratio, devaluation of the US dollar will lessen the risk of higher interest rates resulting in greater deficit spending by the US government as a consequence of increased debt service ($145.4 billion in fiscal 2009) since it will allow the US federal government’s tax receipts to grow faster than the increase in debt service resulting from higher interest rates.

Currently projected US federal government borrowing (or, alternatively, quantitative easing) will maintain downward pressure on the value of the US dollar through the year 2019. According to the US Office of Management and Budget’s (OMB) baseline projection of current policy, federal deficits will total between $7 and $9 trillion for fiscal 2010 through fiscal 2019 and the US public debt will grow from $12.3 trillion to more than $16 trillion in 2019. Other estimates indicate that US federal government debt will exceed $18 trillion in 2019, setting aside the net present value of unfunded federal liabilities based on Generally Accepted Accounting Principles (GAAP). According to David M. Walker, former Comptroller General of the United States from 1998 to 2008 and current President and CEO of the Peter G. Peterson Foundation, current federal liabilities and unfunded obligations total approximately $63 trillion. As a result, further devaluation of the US dollar is inevitable.

Disparate US Dollar Values

Curiously, the US dollar has two different and diverging values, one within the US financial system and another in the broad US economy. As a result of the US financial system rescue, which included purchases of various assets from banks at book value by the US Treasury and Federal Reserve, the US monetary base has expanded roughly 150% since the beginning of the global financial crisis in 2008, but the newly created currency has not filtered into the broad US economy where, in contrast, deflationary pressures persist.

^{Chart courtesy of}^{Federal Reserve Bank of St. Louis}

Although it is not apparent in the broad US economy, the value of the US dollar has been dramatically altered and its devaluation cannot be isolated indefinitely within the financial system independent of the broad US economy. The counterbalancing, but much smaller, contraction of the broad US money supply, as measured by the M3 monetary aggregate, also cannot continue indefinitely.

^{Chart courtesy of}^{Shadow Government Statistics}

At some point, the two disparate values of the US dollar (that found within the financial system versus that found in the broad US economy) will be reconciled and, unless current policies are reversed, the outcome will be a substantially less valuable US dollar. The consequences of the eventual reconciliation will certainly include price inflation in the US, higher US dollar prices for commodities that are subject to global demand, such as oil and gold, as well as higher nominal values for US dollar denominated assets. However, the potential unintended consequences of a falling US dollar include high domestic price inflation, a further reduction in international demand for US debt or a collapse in demand, a disruptive decline in trade, i.e., US imports, or in the worst case, rejection of the US dollar as the world reserve currency or a hyperinflationary collapse of the US dollar.

Is Gold in an Asset Price Bubble?

Diversification for the purposes of risk mitigation and wealth preservation is a rational response to unstable market conditions and is not comparable to a market mania, like the dot-com bubble. Similarly, a long-term shift in asset allocation favoring one general category of assets over another based on fundamentals, while it may result in rising prices, does not by itself describe an asset price bubble.

An asset price bubble, such as the Dutch tulip mania of the 1630s, is an irrational and economically unsustainable investment trend that holds sway over investors only temporarily and that inevitably collapses violently. Asset price bubbles end when a tipping point is reached where the awareness of and tolerance for escalating risk exceed irrational exuberance producing a panic. So long as the great majority of market participants discount risk, individual participants may rely on the irrational exuberance of others. In contrast, rational confidence does not depend on a majority of market participants behaving irrationally and is based instead on sound fundamentals.

The view that rising global commodity prices, fundamentally, are asset price bubbles in various stages of formation unreasonably discounts the risks associated with financial institutions, governments and currencies. If we are to learn anything from Iceland, the Baltic states, Dubai, and Greece it is that if irrational exuberance exists in the financial markets today it is exactly confidence that is not based on sound fundamentals in financial institutions, governments and currencies.

In the 1980 asset price bubble, gold rose from an inflation adjusted low using constant 2009 dollars of $392.57 per Troy ounce on August 31, 1976 ($104 1976 dollars) to its January 21, 1980 peak of what would have been $2,358.04 in 2009 dollars ($850 1980 dollars), a gain using constant 2009 dollars of more than 500% in 4 years. The 1980 asset price bubble in gold violently collapsed in same year, returning to 1979 levels by 1982.

^{Chart courtesy of}^{Bianco Research, L.L.C.}

On April 4, 2001, the gold price would have been $315.78 in constant 2009 dollars, the lowest value since 1970 adjusted for inflation. From that point, the gold price rose from a nominal low of $255.95 on April 4, 2001 to a nominal high of $1,212.50 on December 2, 2009 (London PM fix), a gain of roughly 375% over approximately 10 years (284% using constant 2009 dollars).

^{Chart courtesy of}^{Kitco Metals Inc.}

Over the past decade, the US dollar has declined from its 2002 high by roughly 33% compared to other major currencies and approximately 40% from is 2000 high compared to the Euro. At the same time, most of the currencies in the major indices have been debased alongside the US dollar since 2008 for the same reasons, thus the value of the US dollar in real terms is not apparent from the index alone.

^{Chart courtesy of}^{Federal Reserve Bank of St. Louis}

The alternate US Dollar Indices published by Shadow Government Statistics (SGS) suggest that the Federal Reserve’s trade weighted exchange index of major currencies, which includes the Euro zone, Canada, Japan, the United Kingdom, Switzerland, Australia, and Sweden, may be an optimistic formulation.

^{Chart courtesy of}^{Shadow Government Statistics}

The decline of a national currency, particularly that of a nation with a large trade deficit, is first apparent in international trade while domestic prices do not at first fully reflect the devaluation of the currency. As a result, the prices of commodities that are subject to global demand tend to rise before the general increase in domestic prices that results from currency devaluation, thus the prices of commodities such as gold would be expected to rise faster than domestic measures such as the US Consumer Price Index (CPI).

^{Chart courtesy of}^{Federal Reserve Bank of St. Louis}

The alternate CPI measure provided by SGS may represent a more accurate method of estimating the US dollar prices of commodities that are subject to global demand. The SGS alternate data show accelerating price inflation over the past decade leading up to the global financial crisis in 2008.

^{Chart courtesy of}^{Shadow Government Statistics}

If the SGS alternate CPI data are applied to the gold price it is apparent why Shadow Government Statistics’ John Williams stated in an interview with Bloomberg reporter Pham-Duy Nguyen that if the same methodology of measuring inflation were used today as in 1980, the 1980 gold price would be equivalent to $7,150.

^{Chart courtesy of}^FGMR

While gold certainly has enjoyed tremendous gains over the past decade, including the effect on the gold price of central bank gold demand, the current gold price, following on the heels of an unprecedented global financial crisis, has little in common with the 1980 asset price bubble. The current gold price reflects a rational diversification into hard assets for the purposes of risk mitigation and wealth preservation and can be explained in terms of monetary inflation and associated loss in the value of the US dollar independent of the US dollar carry trade. The continuing devaluation of the US dollar will result in a further rise in the prices of commodities that are subject to global demand, thus the gold price will continue to rise also.

Mr. Soros is certainly correct in that low interest rates contribute to the formation of asset price bubbles, but neither the value of the US dollar or the price of gold depend only on interest rates or on the US dollar carry trade. The view that a gold price over $1000 per Troy ounce represents the “ultimate bubble” ignores the ongoing devaluation of the US dollar, discounts risks associated with the stability of financial institutions, governments and currencies, and does not reflect confidence consistent with sound fundamentals.

Madmen, Gamblers, Alcoholics, the US Dollar and Gold

Ron Hera — Tue, 01 Dec 2009 14:55:00 GMT

If a lawless gang of madmen, gamblers and alcoholics seized control of a large company, how would you expect the business to perform? How would you expect the story to end? What if, instead of a company, they seized control of the world's largest economy, thus, to some extent, the world financial system?

Unsound monetary policy, reckless risk taking, and out-of-control spending are what characterize the US economy today. The proverbial madmen are central bankers, i.e., the US Federal Reserve, whose polices, inspired by Johannes Gutenberg, threaten to destroy the US dollar in the name of saving US banks from their own irresponsibility and greed. The compulsive gamblers are Wall Street investment banks, along with the largest US banks, which have gone so far as to speculate with government bailout money, having learned little from the near collapse of the world financial system in 2008. If money were liquor, the US federal government would be a band of raging alcoholics in charge of a liquor store. These are the tragic characters upon whom Americans depend for their jobs, for their college and retirement funds, for the financing of their educations, homes and business ventures, for the stability of prices and US financial markets, and for the value of their hard earned savings.

The triangle of dysfunction has not gone without notice. Foreign purchases of US Treasury bonds are being made, essentially, under duress while demand for Treasuries remains tepid and quantitative easing by the Federal Reserve continues. The US dollar has fallen from new low to new low and the skyrocketing price of gold is sounding the alarm, but between Washington DC and Wall Street nary an ear can hear.

The Madmen

The incurable incapacity of a central autocracy to accurately match interest rates and the money supply to the requirements of the diverse, complex markets that make up the US economy is a fundamental flaw in US monetary policy. While the ideology may be different, central economic planning under the name of central banking produces no better result than central economic planning under the name of communism. A series of ever larger economic bubbles coupled with an ever weaker currency is ultimately little better than the economic stagnation of the former Soviet system. Low interest rates may stimulate economic activity, for example, but they may also result in high inflation, unsustainable levels of debt, and asset price bubbles.

For every intervention in the free market, whether by government edict or monetary policy, there are unintended consequences. Government intervention in the US housing market, for example, intended to increase opportunities for home ownership among less successful members of society, played a key role in undermining lending standards. Combined with the Federal Reserve's policy of low interest rates, which fueled speculation in real estate and mortgage backed securities, government intervention ultimately proved disastrous.

Markets have existed since the dawn of human civilization without the blessings either of government subsidies and guarantees or of central banking. An economy is best described as an organic system rather than a machine. Interventions purporting to be the processes required to 'operate' the economy are at best futile if not inevitably disruptive and destructive. Like a living organism, the economy is largely self organizing and self regulating. When governments collapse, for example, currencies may fail but trade marches on. The behavior of an economy is an infinitely complex aggregate of individual human actions driven by self-interest and, while it may be characterized at different times either by rationality or by irrationality, it is self correcting (unlike interventions, which know no bounds). As a result, it is not possible for a small group of experts, no matter how intelligent or well intentioned, who have an imperfect understanding and incomplete, inevitably out-of-date information to successfully control the economy without unintended, unexpected and usually destructive consequences.

The notion that a central authority, even one equipped with sophisticated computer models, can successfully substitute a mathematically-based view from on high for the individual judgments of millions of businesses, entrepreneurs, and consumers across countless regions and industries is not merely the height of hubris but quite simply mad. Fundamentally, it is entrepreneurs deploying private capital, not bankers or economists that create the products, services, business, and jobs that make up the economy. Whether for the sake of social welfare or for the purposes of monetary policy, intervention in the free market invariably distorts the distribution of wealth, causes a net reduction of wealth for society as a whole, and misdirects entrepreneurs into activities eventually revealed as uneconomic. Perhaps the best argument for the futility of central bank monetary policy is that of Federal Reserve Chairman Ben Shalom Bernanke, Ph.D., who said to graduates of the Boston College School of Law on May 22, 2009:

"As an economist and policymaker, I have plenty of experience in trying to foretell the future, because policy decisions inevitably involve projections of how alternative policy choices will influence the future course of the economy. The Federal Reserve, therefore, devotes substantial resources to economic forecasting. Likewise, individual investors and businesses have strong financial incentives to try to anticipate how the economy will evolve. With so much at stake, you will not be surprised to know that, over the years, many very smart people have applied the most sophisticated statistical and modeling tools available to try to better divine the economic future. But the results, unfortunately, have more often than not been underwhelming. Like weather forecasters, economic forecasters must deal with a system that is extraordinarily complex, that is subject to random shocks, and about which our data and understanding will always be imperfect. In some ways, predicting the economy is even more difficult than forecasting the weather, because an economy is not made up of molecules whose behavior is subject to the laws of physics, but rather of human beings who are themselves thinking about the future and whose behavior may be influenced by the forecasts that they or others make."

Mr. Bernanke's comments are not remarkable only for their clarity and candor, or because they are a stark admission of the failure of central bank monetary policy, but because they echo the founding principles of the Austrian school of economics. In fact, Mr. Bernanke provides excellent reasons for the repeal of the US Federal Reserve Act. Despite common misconceptions of economics as a branch of mathematics or as a hard science, economics is in fact a social science, similar to psychology. For example, when we speak of economic incentives we are referring to the manipulation of human behavior through artificial means to achieve policy objectives such as increasing consumer spending, just as pairing the sound of a bell with the introduction of dog food will produce dogs that salivate at the sound of a bell when no food is present (of course the salivation response can eventually be extinguished if no food is provided for an extended period of time).

Psychology, it turns out, has a great deal to say about economics, investment banking, and public finance. Indeed, key psychological themes are common to all three areas of endeavor.

The Illusion of Control

There may be a simple explanation, rooted in human nature, for the ever larger disasters brought about by government interventions in the economy and by the institution of central banking. The illusion of control is persistence in the belief that a given outcome can be controlled when no demonstrable influence exists or where, as Mr. Bernanke stated, outcomes cannot be accurately predicted. Whether intervention is the result of central bank monetary policy or of government legislation, taxation or regulation, it is the inherent unpredictability of the outcomes of intervention that belies the philosophy of interventionism itself. Former Federal Reserve Chairman Alan Greenspan, Ph.D., grappled with this fact in the wake of the financial crisis when, in testimony before the US Congress on October 24, 2008, he said:

"... an ideology is [...] a conceptual framework with the way people deal with reality. Everyone has one. You have to -- to exist, you need an ideology. The question is whether it is accurate or not. And what I'm saying to you is, yes, I found a flaw. I don't know how significant or permanent it is, but I've been very distressed by that fact. [That there is a] flaw in the model that I perceived is the critical functioning structure that defines how the world works, so to speak. ... I was shocked, because I had been going for 40 years or more with very considerable evidence that it was working exceptionally well."

Mr. Greenspan accurately refers to the dominant economic theory, not as a science, but as an ideology that ultimately does not conform to reality. In psychological terms, an irrational belief that cannot be modified by reason or evidence is precisely the definition of the term "delusion." Despite his having been confused for 40 years, Mr. Greenspan clearly recognized and acknowledged a limitation of his economic ideology. In retrospect, perhaps Mr. Greenspan regrets having departed from his original views. Sadly, the same cannot be said for the majority of economists, central bankers and US government officials who do not recognize, as Albert Einstein pointed out, that "the definition of insanity is doing the same thing over and over again and expecting different results."

The Gamblers

Gambling addiction and belief in the paranormal, e.g., psychokinesis, are examples of the illusion of control. When rolling dice in the casino game craps, for example, people tend to throw harder for high numbers and softer for low numbers when there is no connection between the force with which the dice are thrown and the result. Experimental subjects can even be made to believe that they can affect the outcome of a coin toss through their level of concentration. The illusion of control is a key factor in gambling addiction because it is reinforced by occasional successes and, as has been long established by behavioral psychologists, behaviors conditioned by intermittent reinforcement are the most difficult to extinguish.

Warning signs of gambling addiction include defensiveness, secrecy, and desperation: precisely the attitudes exhibited by Wall Street bankers seeking bailouts from the US government in 2008. Like US banks transferring private losses to taxpayers, gambling addicts may hold others responsible for their financial problems and they may adamantly insist that they be trusted. Gambling addicts tend to be secretive about finances, while at the same time irrationally insisting on having control over money, just as Federal Reserve Chairman Ben Bernanke has insisted that Congressional review of the Federal Reserve's books. i.e., to find out what financial institutions received taxpayer dollars, would compromise its vaunted independence and harm the US economy. The more gambling addicts are in debt, the more they feel the need to defend gambling and they often defend a specific theory or model that "guarantees" winning (if only they can get more money to continue gambling).

A gambling addict's savings and assets may mysteriously dwindle, perhaps like crumbling bank balance sheets laden with sub-prime mortgages or bank losses associated with risky financial derivatives, and there may be unexplained loans or cash advances, perhaps like the Federal Reserve's Term Asset-Backed Loan Facility (TALF) program. Like banks jacking up credit card interest rates, gambling addicts become increasingly desperate for money to fund further gambling. The debts of gambling addicts may increase sharply, reflecting a "bet more, win more" mentality that inevitably leads to the gambler going bust. Gambling addicts seek money with increasing desperation, perhaps like former US Treasury Secretary (and former Chairman and Chief Executive Officer of Goldman Sachs) Henry M. Paulson's dire warnings of financial Armageddon in 2008. Items easily sold or pawned for money may mysteriously disappear, perhaps like the US government's Fort Knox gold, which is surrounded by rumors and speculation that a long sought (e.g., by the Gold Anti-Trust Action Committee) independent audit could easily dispel.

The Alcoholics

The original Twelve Steps published by Alcoholics Anonymous include admitting that one's life, or in this case the US economy has become unmanageable and that a power beyond one's self (i.e., beyond current economic theories and government policies) is necessary to restore sanity. Contrary to the views of current Goldman Sachs CEO Lloyd Blankfein, the Higher Power cannot be one's self. The self regulating dynamics of a free market, for example would certainly adjust US housing prices to sustainable levels and promote sound lending standards, but this has been prevented by the interventions of the Federal Reserve and US government. Not coincidentally, it was the Federal Reserve and the US government, respectively, that originally caused the inflation of housing prices and undermined lending standards.

Breaking the grip of alcohol addiction requires a searching and fearless moral inventory, admitting the exact nature of one's wrongs, and an unreserved willingness to change and to make amends with those who have been harmed. Sadly, neither the Federal Reserve, nor Wall Street bankers, nor the US Congress, which is committed to borrowing its way out of debt, seem likely to repent.

The destructive behavior of alcoholics is often enabled by dysfunctional, co-dependent relationships. A dysfunctional relationship is one that creates more emotional turmoil than satisfaction, or in the case of the US economy, more destruction of wealth than creation. Warning signs of a dysfunctional relationship include, for example, addictive or obsessive attitudes, an imbalance of power, or a superiority complex on the part of one person. Co-dependency is a pattern of detrimental behavioral interactions within a dysfunctional relationship, most commonly a relationship with an alcohol or drug abuser, but equally possible in a relationship with a gambling addict. The co-dependent is a person who perpetuates the addiction or pathological condition of someone close to them in a way that impedes recovery.

The US government appears trapped, together with the Federal Reserve and Wall Street banks, in a destructive web of dysfunctional, co-dependent relationships. The US government is addicted to the easy money created by the Federal Reserve at the expense of taxpayers who eventually suffer a loss of purchasing power. According to Mr. Greenspan's 1966 article Gold and Economic Freedom, "deficit spending is simply a scheme for the confiscation of wealth." Wall Street bankers depend on US government bailouts and guarantees, as well as on the Federal Reserve's lax monetary policy, and the Federal Reserve depends directly on the US government for the legalization of its unaccountable monopoly and indirectly on the continuation of the largest US banks. While a dysfunctional triangle of co-dependency is merely descriptive, the interdependence of the Federal Reserve, the largest US banks and the US government is a fact in reality.

Unfortunately, it is no more possible to spend one's way to prosperity or to borrow one's way out of debt than it is to drink one's self sober. Nonetheless, thanks to the Federal Reserve's 7 day per week, 24 hour per day money printing service, the US government plans to do precisely this. If creating wealth were as simple as printing money, the dominant school of economics would be led by Robert Mugabe, President of Zimbabwe, and Gideon Gono, governor of Zimbabwe's Reserve Bank (and winner of the 2009 Ig Nobel Prize in Mathematics), who share with Mr. Bernanke a love for the feel of crisp paper and for the smell of fresh ink.

As Milton Friedman once said "The real problem with government is not the deficit. The real problem with government is the amount of our money that it spends."

The wealth destroyed by the collapse of the US real estate bubble and the stock market crash of 2008 has not been and cannot be brought back by bailouts, stimulus spending or outright money printing. While averting a deflationary spiral is necessary, propping up asset prices by dropping money from a helicopter redistributes wealth and interferes with the price mechanism of the free market. Devaluing the US dollar may help to hold up asset prices but it also prevents housing prices from falling to sustainable levels while at the same time adding the risk of eventually far higher prices, or, in the worst case, hyperinflation. There is no historical example of a successfully re-inflated economic bubble. What is more important, however, is that the unintended consequences of currency debasement, i.e., the result of an inflationary monetary policy marked by near 0% interest rates, are likely to outweigh the goals of the policy even if they are achieved.

Reducing the value of debts in real terms through currency debasement requires a commensurate loss of purchasing power, thus while housing prices may be prevented from falling further, savings will be destroyed and wages will lag behind prices once they inevitably begin to rise. Although consumer prices in the US currently lag behind the downtrend of the US Dollar Index (USDX), an inflation tax will eventually be levied. Under the name "economic stimulus", wealth is being dissipated by the US government at an alarming rate with no sustainable benefit. US government programs like Cash for Clunkers only impact short-term economic data while, in reality, destroying wealth, increasing debt and diverting consumer spending into already bankrupt industries. At the same time, the US government is eager to increase tax revenues to offset deficit spending and it has all manner of businesses, as well as wealthy individuals in its crosshairs. German-born Presbyterian clergyman William Boetcker (1873-1962) wrote:

"You cannot bring about prosperity by discouraging thrift. You cannot help small men by tearing down big men. You cannot strengthen the weak by weakening the strong. You cannot lift the wage-earner by pulling down the wage-payer. You cannot help the poor man by destroying the rich. You cannot keep out of trouble by spending more than your income..."

Boetcker's words are profound. It is not possible to repair the US economy through stimulus spending or to increase the wealth of consumers by inflating asset values via currency debasement. Supporting asset prices, thus bank balance sheets, via currency debasement, in the best case, can spread debt defaults over time, perhaps delaying the collapse of bankrupt financial institutions. However, currency debasement promises to move Americans closer to the financial status of Zimbabweans due to the destruction of the purchasing power of the US dollar. A less valuable US dollar will reduce consumer spending in real terms, and reduced consumer spending will impact businesses and, therefore, jobs.

The US Dollar and Gold

The price of gold indicates a lack of confidence in the US dollar and in the US economy and it reflects poorly on the credibility of the Federal Reserve and of the US government. The changing composition of central bank reserves, e.g., increasing gold holdings, is a direct effect of the currently weak US economy and US dollar, which has lost considerable value in recent months. In contrast, gold is the only financial asset, in fact a currency that has no counterparty risk. This simple, but often overlooked fact goes a long way to explain current investment demand for gold.

Chart courtesy of StockCharts.com

All other things being equal, strong economies offer investors superior returns and lower risk compared to weak economies, thus the currencies of stronger economies are always preferred over those of weaker ones and have a higher relative value as a function of supply and demand. Of course, monetary inflation and monetary deflation also influence the value of a currency in terms of supply.

In a world financial system composed entirely of fiat currencies, where no currency is redeemable in terms of hard assets, money is an abstract claim on production and the value of one national currency relative to another can only, ultimately be a reflection of the performance of the underlying economy that the currency represents (performance being inclusive of the consequences of its monetary policy), i.e., a claim on its production. Thus, if an economy is in decline, i.e., its production is falling, its currency, over time, must also decline. Conversely, there can be no doubt that if the US economy were exhibiting credible and significant growth, i.e., if production were increasing, the US dollar would certainly gain value, but that is not the case.

Chart courtesy of StockCharts.com

The fact that central banks are reducing US dollar holdings and increasing holdings of other currencies, including gold, is simply a matter of preserving the value of their reserves in the face of developments influencing the value of the US dollar, such as the burgeoning US dollar carry trade. Having gone "all in" to save the largest banks, the Federal Reserve and US government continue to assume that the crisis can be managed, despite the fact that their policies are making the situation worse in terms of sustainable housing prices, public debt and the value of the US dollar. In the mean time, Wall Street bankers have gone back to the casino, nonchalantly cashing in their bailout chips and pocketing the gains.

The rationale of buying time for US banks and of supporting US real estate prices seems reasonable on its face but this probably doomed policy is already proving counterproductive. Despite the patina of economic recovery sprinkled over the news media like fairy dust, small business and commercial real estate failures, as well as ongoing residential mortgage and credit card defaults, are rippling through the weak US economy, while unemployment continues to rise undermining consumer spending thus, ultimately, bank balance sheets. Setting aside the understandable reluctance of US banks to make new loans, no amount of tenuous good news, no matter how exaggerated, has been able to rekindle the frenzy of consumer borrowing that formerly characterized the US economy.

The illusion of control is a temporary state of affairs. The triangle of dysfunction and co-dependency formed by the Federal Reserve, Wall Street banks, and the US government is like a story about a madman, a gambler and an alcoholic, where each traps the others in their respective downward spirals. The illusion of control, common to all three, is gradually bringing about a situation that will inevitably be entirely out of control, but, as with gambling addicts and alcoholics, the point where control is lost can only become apparent after the fact, just as the financial crisis of 2008 caught the vast majority of experts by surprise.

Investors, governments and central banks around the world are seeking safety outside the US dollar, particularly in gold, as well as outside of the US stock market, e.g., in emerging economies. The more borrowed money the US government spends, the more money the Federal Reserve prints and the longer zombie banks are kept on life support, the worse the eventual condition of the US economy, the weaker the US dollar and the higher the price of everything in US dollars will ultimately be, particularly gold.

Ganesha and the Price of Gold

Ron Hera — Sat, 14 Nov 2009 02:26:00 GMT

The fact that investors around the world are turning to gold is remarkable. Unlike a bond, stored gold offers no yield and, unlike a stock, gold provides no leverage to the performance of an enterprise. Buying gold is not an investment per se, compared, for example, to buying a gold mining stock, where a company's financial performance is linked to its resources and production, at the same time providing leverage to the gold price. In fact, industrial applications for gold consume far less than the annual supply, thus investing in gold is fundamentally different from other commodities. According to the World Gold Council (WGC), investment demand for gold, e.g., from Exchange Traded Funds (ETFs), was up 46% in the third quarter of 2009.

Gold is commonly viewed as an inflation hedge and, because it is the only financial asset with no counterparty risk, as a safe haven, but the spectacular rise in the gold price indicates more than caution on the part of investors. Gold hit a low of $713.50 per troy ounce on November 13, 2008 (London Bullion Market Association PM Fixing) and closed at a 52-week high of $1,115.25 on November 11, 2009, up an astounding 56.31% from its 52-week low.

Chart courtesy of StockCharts.com

Central bank gold is the proverbial elephant in the room that no one wants to talk about. With official gold holdings of 29,633.9 tonnes of gold worldwide, compared to world gold production of roughly 2,400 tonnes per year, central bank gold sales, leases and purchases, have a huge influence over the gold price. Central banks are changing their reserve asset compositions and a number of central banks, led by India and China (which has been the world's largest gold producer since 2008), are buying gold. Evidently, the full faith and credit of the United States of America isn't what it used to be. Faced with a weakening world reserve currency, the questionable status of the world's largest economy, and unsustainable US government spending, central banks are rendering a quiet vote of no confidence on the US dollar.

The US economy, the US government, US banks, and US stock markets exhibit various problems including unemployment, looming commercial real estate defaults, the US budget deficit, a massive public debt and huge unfunded liabilities, residual toxic assets on bank balance sheets, mounting mortgage defaults and credit card delinquencies, an emerging stock market bubble, etc. Unless the economic problems of the US can be addressed, the US dollar will quite probably loose its status as world reserve currency. Whether a transition to a new world reserve currency would take place in a cooperative manner, e.g., a managed retreat of the US dollar, or in a more disruptive way is unclear.

Gold Supply and Demand in 2009

Under ordinary economic conditions, a rising gold price might reflect, for example, increased demand, the effects of currency debasement or inflation expectations, but a sustained rise in the gold price characterized by growing global investment demand indicates something more. New York University Professor of Economics Nouriel Roubini has suggested that commodity prices reflect an emerging global asset price bubble fueled by the fast-growing US dollar carry trade. While Professor Roubini's "mother of all carry trades" thesis accounts for the effects of low US interest rates driving global speculation and a decline in the US dollar, it does not specifically consider gold, which has unique supply and demand characteristics.

Based on data provided by the WGC, Gold Fields Mineral Services Ltd. (GFMS), and the US Geological Survey, the world gold supply is expected to be approximately 2,400 tonnes in 2009. Gold demand is expected to exceed supply by roughly 1032 metric tonnes (1 metric tonne is the equivalent of 32,150.7466 troy ounces), a large shortfall equal to 43% of the gold supply.

Assuming the average decline in industrial consumption for all of 2009, compared to 2008, will be roughly the same as that of the most recent quarter:

The jewelry industry, by far the largest industrial consumer of gold, is expected to consume roughly 1,705 tonnes of gold by the end of 2009. Jewelry demand was down 22% in the third quarter and is expected to account for only 71.04% of the 2009 gold supply.
The electronics industry, where consumption was down 25% in the third quarter, is expected to consume roughly 76.1 tonnes of gold by the end of 2009.
The field of dentistry, where consumption was down 11% in the third quarter, is expected to consume roughly 49.75 tonnes of gold by the end of 2009.
For all other industries, where consumption was down in the third quarter an average of 9%, total consumption is expected to reach 79.08 tonnes of gold by the end of 2009.

Total industrial demand is, therefore, expected to reach 1,909.93 tonnes of gold by the end of 2009, or approximately 79.58% of the estimated 2009 gold supply.

Although gold is not actually circulated as money, gold coins and bullion bars are in high demand and investment demand was up 46% in the third quarter. Investment demand is expected to account for roughly 1,727 tonnes of gold in 2009, an amount that exceeds the demand of any single industry.

Outside of the electronics industry, where scrap gold recovery is high, and the field of dentistry, gold is not typically consumed destructively. As a result, unlike any other commodity, the vast majority of gold mined throughout history, estimated at 162,780 tonnes by the end of 2009, remains in existence today.

Central Bank Gold and the US Dollar

Despite the fact that it is not generally used as money, gold is held by central banks as a currency reserve and official central bank gold holdings amount to 29,633.9 tonnes worldwide. Official gold holdings represent roughly 18.2% of all gold ever mined and the expected 2009 gold supply is equivalent to roughly 8.1% of official gold holdings.

Since gold no longer served an official monetary purpose after 1971, which marked the end of the Bretton Woods system, central banks began to sell and to lease gold based on their individual requirements and continued to do so until 1999. Prompted by the UK Treasury's planned sale of 415 tonnes of gold (58.04% of UK gold reserves at the time), the Washington Agreement on Gold was established in 1999 to maintain the value of remaining central bank gold reserves by coordinating central bank gold sales. Under what is now the Central Bank Gold Agreement (CBGA), central banks have sold gold in limited quantities (400 tonnes annually between 1999 and 2004, 500 tonnes annually between 2004 and 2009, and 400 tonnes in 2009). However, official sales do not account for gold leasing.

Central banks lease gold to earn interest thus offsetting storage costs by leveraging what had been until this year an otherwise marginalized financial asset to generate cash flow. Rather than borrowing cash at higher interest rates, gold producers, for example, may lease gold and sell it to raise cash, paying the lessor in physical gold from future production. Gold dealers may wish to lease gold in order to cover derivative positions, such as options or futures, either paying the lessor in physical gold or settling contracts in cash. In cases where leased gold is sold by a lessee into the open market, the gold supply is affected, which might affect the gold price. Although gold lease rates, which have been historically lower than interest rates, and central bank participation in gold leasing arrangements are documented by the London Bullion Market Association (LBMA) and other organizations, gold leasing remains an unregulated market. Since gold leases can be settled either in gold or in cash, it is difficult to calculate the effects of gold leasing on the supply and demand dynamics of gold or on the gold price. In any case, since 2008, central banks have reduced gold leasing at traditionally low rates, e.g., rates below 1%.

What is more important is that central bank gold sales had begun falling short of the annual sales allotment of the CBGA in 2006, declining to an estimated 345.5 tonnes in 2008. Since 1999, the gold supply has averaged approximately 2495 tonnes per year, while central bank gold sales through 2008 averaged an estimated 394 tonnes, equivalent to 15.8% of annual supply on average. In 2009, however, central banks became net buyers of gold and some central banks began to repatriate gold reserves. China, for example, began adding gold to its reserves and India recently agreed to purchase 200 tonnes of gold from the International Monetary Fund (IMF).

Setting aside gold leasing, central bank gold sales, having effectively added an estimated 15.8% annually to the gold supply for the past decade, can only have had a dampening effect on the gold price and as well as on gold investing. Therefore, the effect of central banks rather suddenly switching from net sellers of gold to net buyers of gold is equivalent to a reduction in the 2009 gold supply of approximately 15.8%.

In addition to the projected 43% shortfall in the 2009 gold supply, the US dollar's precipitous decline led to a rise in commodity prices across the board. The US Dollar Index hit a 52-week low of 74.93 on November 9, 2009, down approximately 16.39% from its 52-week high of 89.624 on March 4, 2009.

Chart courtesy of StockCharts.com

Demand for gold in 2009 is expected to exceed the supply by 43%, including a reduction in supply of approximately 15.8% due to the effective termination of central bank gold sales, while the US dollar is down approximately 16.39%. At the same time, there has been a fundamental shift in central bank policy. Eastern central banks in particular, led by India and China, are buying gold, while Western central banks have cut back gold sales and have reduced gold leasing at traditionally low rates.

Setting a Gold Price Target

The 16.39% decline of the US dollar tends to be reflected rather directly in commodity prices, thus the gold price, considering that the demand for gold is global, could reasonably be expected to rise approximately 16.39% from its 52-week low in 2009 based solely on the decline in the US dollar.

The effect on the gold price of the 2009 supply shortfall of 1032 metric tonnes could be extraordinary if obvious shortages were to occur, or it might be nominal if consumers of gold were to substitute another commodity, e.g., silver. Substitution, however, seems very unlikely both in terms of industrial uses for gold and in terms of investment demand. Thus, a naive estimate of the impact of the supply shortfall on the gold price might assume that the gold price would rise no more than the shortfall in supply, i.e., by no more than 43% (inclusive of the estimated 15.8% reduction in supply due to the effective termination of central bank gold sales and setting aside entirely the subject of gold leasing).

Combining the 16.39% decline of the US dollar and the estimated 43% shortfall in supply might suggest a gold price approximately 62.6% higher than the 52-week low of $713.50 (London PM Fix), which occurred on November 13, 2008, 1 year ago, i.e., a naive price target of 1,160.15 as of November 2009. The 52-week high of $1,115.25 on November 11, 2009 was approximately 56.31% higher than the 52-week low, thus the actual gold price at that point was lower by roughly 6.29% compared to the 52-week low than the naive price target of 1,160.15. Based on these estimates, the gold price does not seem to indicate an asset price bubble.

Which Way is the Elephant Going?

The proverbial elephant in the room is on the move and the room is not very big in comparison. It seems likely that Western central banks are holding off further gold sales, at least while discussions on a new world reserve currency, i.e., IMF Special Drawing Rights (SDRs), are taking place. Led by India and China, key IMF members want gold included as a component of the a world reserve currency. As long as using gold as a component of a new world reserve currency is a possibility, not only are central bank gold sales on hold but central banks will almost certainly continue to buy gold in the foreseeable future.

There is no fundamental reason for the current gold price trend to reverse in the foreseeable future, and, despite the steep rise of the gold price in 2009, gold does not appear overvalued. It seems possible, although unlikely, that if gold were to again be marginalized in a new world reserve currency regime, as it was under the US dollar standard after 1971, central banks might again start selling and more aggressively leasing gold at some point in the distant future. In that case, the gold price would eventually fall, perhaps to some stable, lower level, once again reflecting the conflicting desires of central banks to both leverage their gold reserves and also maintain their value. However, given the global financial crisis stemming from of the US dollar's 64-year reign as world reserve currency, it seems much more likely that central banks will guard their hoards jealously in coming decades.

Alternatively, if a new world reserve currency were to emerge having a significant gold component, what would then be a certainly higher gold price would likely remain at a higher level indefinitely. It also remains possible that the decline of the US dollar could accelerate or that the apparent differences between Eastern and Western central banks could become more acute, in which case the gold price could rise more rapidly and the process of deploying a new world reserve currency might be accelerated as well as potentially disruptive.

The Hindu deity Ganesha, widely revered as the Remover of Obstacles, is readily recognizable because he has the head of an elephant. Gold languished from 1971 until 2009 as a commodity that central banks had little better to do with than to systematically dissipate through sales and leases, while the most significant problem they thought they faced was the risk of dishoarding too much too quickly. From 1971 until 2009, central bank gold entering the market was a factor of the gold price and a risk for investors. After 38 years, the effective termination of central bank gold sales has rather abruptly removed that obstacle.

Desiring to mitigate risks associated with the US dollar, central banks, led by India and China, have, in effect, promoted gold from its 38-year status as a non-financial commodity once again to its historical role as the premier global financial asset. This historic change in central bank policy signifies a profound break with the past and broadcasts a clear message: gold is a world-class financial asset fairly valued at more than $1,000.00 per troy ounce. With this momentous event, the words "as good as gold" again have meaning.

An analysis of supply and demand fundamentals suggests that the current gold price does not indicate an asset price bubble, and the historic change in the status of gold by central banks implies a major revaluation not yet reflected in the gold price. As the restructuring of the global economy continues, particularly with respect to the world reserve currency, there is a clear possibility that the gold price will move up sharply from current levels.

China’s Dragons: Oil, Gold, and the US Dollar

Ron Hera — Fri, 23 Oct 2009 20:29:00 GMT

The end of the de facto petrodollar standard has profound and lasting implications for the US dollar, oil, and gold. The US is the epicenter of the global financial crisis and economic downturn, but the US continues to exercise disproportionate control of the oil trade and to enjoy the unique status of the US dollar as the world reserve currency. The inflationary policies of the US government and Federal Reserve have damaged the US dollar to the point that it is increasingly seen as a destabilizing force in the world economy. To make matters worse, it was principally the US that manufactured the financial derivatives that still menace the global financial system (China has opted out). There is growing recognition that the US economy is on an unsustainable course and this fact has fueled an international movement towards a new world reserve currency.

China has emerged as a major player in the currency chess game and in the gold market, and China is the second largest consumer of oil. China is the largest US creditor holding $797.1 billion in US Treasury debt and a net creditor nation with reserves equal to $2.273 trillion. Nonetheless, China is leading the charge against the petrodollar standard and the US dollar's privileged status as the world reserve currency. China is not merely seizing the opportunity presented to it by the global financial crisis but is pursuing an ongoing economic strategy that includes a larger domestic market for its own goods and services, greater influence over the global economy, a stronger yuan, and a secure energy supply.

"The good fighters of old first put themselves beyond the possibility of defeat, and then waited for an opportunity of defeating the enemy. To secure ourselves against defeat lies in our own hands, but the opportunity of defeating the enemy is provided by the enemy himself." - Sun Tzu, The Art of War, circa 610 BCE

Developing and implementing a new world reserve currency is a nontrivial proposition and it will take time. However, in practical terms, the key factor that stands in opposition to a new reserve currency is the petrodollar standard. The petrodollar standard allowed the US to print vast quantities of US dollars without high domestic price increases because steady international demand strengthened the US dollar, thus moderating prices in the US, e.g., the prices of oil and of gold. The petrodollar standard, which can be undone in a relatively short period of time, is the Achilles' heel of the US dollar's world reserve currency status. What is more important, however, is that ending the petrodollar standard will put massive upward pressure on prices in the US: a fact that few have recognized.

While the US monetary base has roughly doubled since the start of the financial crisis in 2008, the money created to recapitalize US banks remains in the banking system and has yet to influence prices in the US (aside from the prices of inflation hedges such as gold and silver, which are in high demand). The most broad measure of the US money supply (M3), no longer officially measured, has actually declined according to Berkeley, California-based Shadow Government Statistics. Thus, the most useful monetary inflation analysis is that of Paul van Eeden, President of Cranberry Capital, Inc. Mr. van Eeden's Actual Money Supply (AMS) model indicates a 12-month moving average of 8.44%.

Chart courtesy of Paul van Eeden

The average monetary inflation rate, estimated at approximately 8% per year over the past 38 years, compounded annually, shows that the US money supply increased by roughly 1,863% since 1971. However, according to the US government, prices in the US have increased only 533% since 1971, a 1,330% differential. The number of US dollars exploded on a global basis to accommodate the growth in US dollar transactions, i.e., international trade, especially oil, and currency reserves.

China is the second largest US trading partner and the primary source of the chronic US trade deficit. As trading partners, the Chinese and US economies are linked by the US dollar, but compete for oil, currently priced in and purchased with US dollars. China needs more oil and wants to buy it with Chinese yuan. By buying gold and encouraging gold ownership, the Chinese government is betting against the US dollar and positioning the yuan to become a universally accepted transaction medium. China is quietly diversifying out of US dollars, buying resources and hard assets. Ending the petrodollar standard will allow China to buy oil in yuan and make the yuan a more viable currency internationally while, at the same time, clearing the way to take on a larger role in the global economy.

Currencies are being debased throughout the western world in the hope of saving banks, stimulating economic activity and restoring trade. Until the US reverses course, or until a new reserve currency is in place, gold will continue to shine. Gold investment and central bank demand will likely remain strong because gold can function as a commodity, as a currency and also, unlike the US dollar, as a store of value immune from the hazards of currency devaluation caused by monetary inflation. As the only financial asset without counterparty risk, the historical reasons for holding gold, all but forgotten during the 1990s, have never been more clear.

The end of the petrodollar standard and eventually of the US dollar's world reserve currency status combined with increased demand for oil and gold, particularly on the part of China, is a fundamental restructuring of the global economy already in progress.

US Dollars, Asian Tigers

While commodity prices, measured in US dollars appear to be rising, one of the fundamental forces behind the upward trend is the decline of the US dollar. Commodity prices are not rising as much in real terms as is suggested by their nominal prices because the US dollar is declining in value. As the US dollar falls, the prices of commodities, measured in US dollars, rise.

The perfect storm for the US dollar comprises the consequences of past decades of monetary inflation punctuated by the dot-com and housing bubbles; excessive levels of debt in the US economy (hampering a US economic recovery); the poor condition of US banks whose balance sheets, still burdened with toxic assets, continue to deteriorate; an expanding Federal Reserve balance sheet that includes toxic assets; extraordinary spending by the US federal government driven by Keynesian economic policies and by what are most probably economically unworkable socialist programs; rapidly declining foreign appetite for US debt; quantitative easing ("money printing"); near 0% interest rates and a growing US dollar carry trade; not to mention the imminent end of the petrodollar standard, and the eventual end of the US dollar's status as the world reserve currency. At the start of the global financial crisis and economic downturn, the US dollar rallied in a global flight to the then perceived safety of US dollars and US Treasury bonds. However, pressures on the US dollar have mounted and it has begun a precipitous decline.

Chart courtesy of StockCharts.com

What is important about the US Dollar Index (USDX) is that other currencies in the basket (the Euro, the Japanese yen, the British Pound, the Canadian dollar, the Swedish krona, and the Swiss franc) are also loosing value as a result of inflationary central bank and government policies, but not as quickly as the US dollar.

The USDX was created in 1973, two years after the US dismantled the Bretton Woods system (where the value of the US dollar had been pegged to the price of gold and other currencies were pegged to the US dollar) and one year after former US President Richard Nixon opened relations between the US and China. Today, the sleeping giant, noted by Napoleon, is wide awake, and Asian currencies are rising against the US dollar. China is issuing yuan denominated bonds and growing Asian demand for key commodities, particularly oil, can be expected to maintain upward pressure on prices measured in US dollars.

The economic might of the four Asian Tigers (Hong Kong, Singapore, South Korea, and Taiwan) would have been inconceivable when the USDX was created. Today, the Group of Twenty (G-20) Finance Ministers and Central Bank Governors includes representatives from China, India, Japan, South Korea, and Indonesia, and the International Monetary Fund (IMF) includes the so-called BRIC countries (Brazil, the Russian Federation, India, and China) in addition to Japan and oil producers Saudi Arabia and Venezuela. Whether the USDX remains today an accurate or meaningful measure of US economic power from a global perspective is unlikely. In any case, US and European economies and banks are currently in quite poor condition compared to those of Asia; a fact that does not support rising currency values for western countries.

China's population of 1.333 billion, compared to roughly 308 million in the US, represents the largest emerging market in the world, and China's already substantial consumption of resources is growing rapidly. With a population 4.3 times larger than that of the US, Chinese consumption need reach only 23% of that of the US, on a per capita basis, to equal total US consumption. Conversely, if the Chinese were to consume half as much as Americans on a per capita basis, total Chinese consumption would be more than twice that of the US. Changes in the behavior of Chinese consumers already have the potential to create disruptive shifts in commodity markets on a global basis, and China's rising influence is only just beginning to be felt, e.g., in the gold market.

The S&P Goldman Sachs Commodity Index (GSCI), which contains 24 commodities (including energy, industrial and precious metals, agriculture, and livestock), is designed to minimize the impact of events that affect individual commodities and to respond in a stable way to world economic growth.

Chart courtesy of StockCharts.com

Interestingly, from a technical perspective, the GSCI chart exhibits a clear inverse head and shoulders pattern followed by a breakout to the upside. Spurred by the financial crisis, China began putting its massive reserves to work in wide ranging global investments, systematically trading its US dollars for resources and other hard assets.

China's Seven Dragons

The five dragons of the ancient Chinese zodiac (fire, earth, metal, water, and wood) are suggestive of China's tremendous natural resources, which include coal, iron ore, oil, natural gas, mercury, tin, tungsten, antimony, manganese, molybdenum, vanadium, magnetite, aluminum, lead, zinc, uranium, as well as the world's largest hydropower potential.

Chart courtesy of Mint Software, Inc.

Together, Asian countries account for 60% of the earth's human population and control major portions of world resources such as corn, cotton, gold, rice, rubber, silver, water, and wheat to name only a few.

If the Chinese calendar had been invented more recently it might include more specific varieties of each animal, such as a gold dragon in the metal category and an oil dragon in the earth category, thus there would be seven celestial dragons rather than five.

The Oil Dragon

Total Asian demand for oil, lead by China's 7,880,000 bbl/day, exceeds US consumption. In fact, the consumption of just China, Japan, and the four Asian Tigers is greater than that of the entire EU. Taken as a whole, Asian demand for oil is more significant for the price of oil than the US or the EU. The price of oil in 2009 has risen as Asian economies began to recover, despite lower US consumption. Rising Chinese demand for oil is now a fixed feature in the otherwise changing global economic landscape. A weaker US dollar and a stronger Chinese yuan serve to guarantee that China will have the oil it needs.

Although not as hard hit by higher oil prices as less developed countries (which could be priced out of the market entirely) would be, the US economy could be crippled by high oil prices. As shown by the West Texas Intermediate Crude Oil index (WTIC), the price of oil is rising sharply.

Chart courtesy of StockCharts.com

Both the US and China import roughly twice as much crude oil as they produce. With a weaker dollar, US oil imports, currently roughly $400 billion annually, will represent a larger external drain on the US economy, which could prove to be disruptive. The reactionary US strategy is to increase domestic oil production and to develop alternative energy sources in order to reduce dependency on foreign oil. Unfortunately, US oil production cannot increase quickly enough or to high enough levels to ameliorate the impact of much higher oil prices. Presently, there is no alternative energy technology that can supply enough energy at a low enough cost to have a significant impact on US oil consumption in the near term. An anemic US economy combined with a weaker currency means that the US is ill equipped to absorb inevitably, much higher oil prices.

The Gold Dragon

Oil is the most important factor of the US dollar's value for two reasons. Since the founding of the Organization of the Petroleum Exporting Countries in the 1960s (currently Algeria, Angola, Ecuador, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab Emirates, and Venezuela), oil has been priced in and sold in US dollars worldwide. Since the Bretton Woods system ended, the effect of the OPEC cartel's price fixing actions has been to establish an implicit commodity-based value for the US dollar. In other words, after the Bretton Woods system, the value and the world reserve currency status of the US dollar was implicitly supported by oil rather than gold. Any nation accepting US dollars in trade knew what the value of US dollars was measured in oil.

Once oil is no longer priced in US dollars, the US dollar, in practical terms, will no longer be the world reserve currency, i.e., US dollar transactions will decline sharply on a global basis. This conclusion has already been recognized by central banks. In the second quarter of 2009, US dollars accounted for only 37% of new central bank assets, compared with 70% in the past. Rather than US dollars, central banks favor Euros, Yen, and gold. Central banks have also become net buyers of gold or are repatriating gold reserves.

Following the replacement by Iran (the third largest oil producer) of the US dollar with Euros for foreign trade in September, 2009, rumors emerged of secret talks between Arab states, China, Russia, Japan and France, allegedly regarding replacing the US dollar with a basket of currencies including the euro, Japanese yen, Chinese yuan, and gold. Talks between Russia and Iran regarding conducting oil transaction in rubles were officially acknowledged a few days later by Russian Information Agency Novosti (RIA Novosti). Neither development is at all surprising because world leaders have been calling for the replacement of the US dollar as the world reserve currency since 2008. It's safe to say that all of the BRIC nations, especially China and Russia (the world's 8th largest oil producer), oppose the petrodollar standard and are in favor of a new reserve currency (Brazil's largest trading partner, formerly the US, is now China).

It seems unrealistic to imagine that currencies tied to growing economies with higher production and lower levels of debt would not be preferred over those of stagnated economies. If political strength follows economic strength, the petrodollar standard will soon take its place in history alongside the defunct Bretton Woods system.

Setting aside all other considerations, the price of gold would be $815 per ounce today based only on US dollar monetary inflation using Paul van Eeden's AMS model, i.e., 30% below the spot price (approximately $1,060 US at the time of this writing). Mr. van Eeden has accounted for the increase in gold over time.

Chart courtesy of StockCharts.com

It is worth noting that the price of gold, when adjusted for inflation, is nowhere near its 1980 peak. The current situation is fundamentally different from the brief but acute 1980 gold price bubble. John Williams of Shadow Government Statistics maintains that the US government has understated inflation and recently said that "If the methodologies of measuring inflation in 1980 had been kept intact, gold [adjusted for inflation] would have to hit $7,150 to be the equivalent of the 1980 record,"

According to data from the World Gold Council (WGC) and metals consultancy GFMS, demand for gold is currently greater than the supply by as much as 1000 tons per year. The WGC and GFMS have correctly identified two distinct economic spheres comprising gold supply and demand. In the western economies, jewelry and industrial demand are weak, but investment demand is strong, while outside the western economies broad gold demand continues to grow. India remains the largest buyer, while gold demand in China is rising. China has been aggressively adding gold to its reserves and has not only made it legal for Chinese citizens to own gold but is encouraging gold ownership. The potential influence of increased, long-term Chinese demand on the price of gold cannot be ignored.

Monetary inflation and supply and demand considerations are not the whole picture. There is a much deeper reality. For nearly four decades, gold, priced in US dollars, was implicitly linked to oil and the resulting demand for US dollars moderated the affects of monetary inflation on prices in the US. The end of the petrodollar standard and the resulting global decline in demand for US dollars will cause the price of gold to rise significantly. The value of the US dollar changed qualitatively after 1971 when it became an irredeemable pure fiat currency, no longer backed by gold; a fact that has been masked by the petrodollar standard.

Higher demand for gold also reflects a growing recognition that the US dollar and other currencies currently being devalued are not reliable stores of value. In fact, the US dollar has not been a store of value at all for 38 years during which massive quantities of fiat money, including trillions of petrodollars, flooded the global economy. The weakness of the US dollar exposed by the financial crisis, i.e., its inability to function as a reliable store of value regardless of its utility as a transactional medium, points exactly to the strength of gold. The decline in international demand for US dollars, rejected as a failed store of value, indicates strong demand for gold in the foreseeable future.

18th-century French philosopher and writer Voltaire once said that "paper money eventually returns to its intrinsic value - zero". Understandably, Voltaire failed to consider a world where all money was purely transactional rather than a store of value, and where the relative values of currencies were managed in a loosely coordinated manner by central banks and governments through manipulation of the money supply, interest rates, etc. In theory, such a world could function indefinitely provided that currencies were relatively stable; provided that currencies were widely accepted and interchangeable; provided that large trade imbalances did not destabilize the system; and provided that currencies were not debased excessively, i.e., in a reckless or irresponsible manner, which would lead to a variety of economic problems. However, Voltaire's inability to imagine such a world may be insufficient cause to dismiss his observation.

It seems possible that Voltaire's superficially antiquated understanding was precisely that "paper money" can never function in the long run as a store of value, i.e., that it will inevitably, either by accident or by design, be mismanaged, and that it will always, eventually, be rejected, thus rendering its intrinsic value clear. History certainly supports Voltaire's view in that fiat currencies tend to perish. As recently as 1999, referring to the sale of British gold reserves, Alan Greenspan, then Chairman of the US Federal Reserve, said that "Fiat money paper in extremis is accepted by nobody. Gold is always accepted." As the Chinese discovered in the 11th century, money has a qualitative dimension and for "paper money" that dimension is confidence. In contrast, because it is a tangible asset that required an investment of human labor and other resources to produce, the value of gold does not ultimately, in extremis, depend solely on the unreliable subjective feeling of confidence.

Xiangqi (Chinese Chess)

There is increasing international recognition of the fact that there is no foreseeable end point to the devaluation of the US dollar. The inflationary policies of the US federal government and Federal Reserve have all but exhausted confidence in the US dollar both at home and abroad, above all as the world reserve currency. This entirely rational loss of confidence is the root cause of expanding multinational efforts to end the petrodollar standard and to eventually establish a new world reserve currency.

A reversal of the escalating challenge to the petrodollar standard and the movement away from the US dollar as the world reserve currency would require oil producers and industrialized nations, including China, to rally in support of the US, but it is precisely this group (a group that includes OPEC members, the BRIC countries, members of the G-20, and voting members of the IMF), that is seeking to free itself from US dollar hegemony. Rather than attributing the petrodollar standard and the status of the US dollar as the world reserve currency to the wealth, power and influence of the US, critics assert that the wealth, power and influence of the US is illegitimate and that it is the result of undeserved privileges; privileges that have been abused at the expense of nations that do not enjoy unfair advantages and that must now be forfeited.

Skeptics regarding the rise of China as a major economic power doubt that China can profit from a weaker US dollar through a stronger yuan or develop a sufficient domestic consumer market quickly enough to offset reduced exports. However, while China contributes to US consumption as an export-dependent supplier, as well as a financier, their exposure to losses resulting from a declining US dollar is limited. A stronger yuan would mean that, after a period of adjustment, China would import more goods and services and that, in real terms, wages of Chinese workers would increase, thus supporting a higher standard of living. What is more important is that a stronger yuan, implicitly backed by growing gold reserves (not to mention by a large and fully modern navy), is exactly what will guarantee China's oil supply.

The struggling US economy, burdened with excessive levels of debt, cannot support a sustained rise of the US dollar against the currencies of growing economies in Asia. Growing demand for resources, especially oil, as well as gold, contrasted with the inflationary policies of the US, will maintain the upward trajectory of commodity prices measured in US dollars indefinitely. In the near term, the end of the petrodollar standard will cause a sharp decline in the value of the US dollar and a marked increase in the prices of oil and of gold measured in US dollars.

Faces of Death: The US Dollar in Crisis

Ron Hera — Sun, 11 Oct 2009 08:45:00 GMT

The US economy has been in crisis since 2008 and despite optimistic statements by officials and commentators there are no fundamental signs that the crisis will end in the foreseeable future. Current economic data suggests a number of diverging and unsustainable...(read more)