The Good, the Bad, the Ugly II

The current situation with Iraq does not bode well for the future economic well being of America.

Firstly, now that the coalition has declared military success it will only mean the end to the easy part of the entire exercise. The administration of Iraq under the auspice of the U.S. military and the effort to create a functioning democracy may end up being a long and bloody exercise indeed.

History has shown that the Middle East does not respond well to occupation by the West. From the Crusaders to the Brits, the eventual outcome is always an exhausted retreat. Trying to impose democracy on a region populated by a multitude of sects and tribes that all hold grudges that go way back (in some cases more than a thousand years) and was only held together with totalitarian force, may be challenging to say the least.

Furthermore, given that the U.S. will have influence as to which specific Iraqi groups and people will be allowed to participate in this process, it will create further suspicion and turmoil. Democracy is a concept that must evolve, with groups of people that wish to live together and with a proper institutional infrastructure in place. I doubt it can be ordained at will.

The “Liberation” of Iraq: A Much Larger Plan

Secondly, whatever is being promoted as the reason de jour behind the invasion (oops, I mean liberation) of Iraq, i.e. elimination of weapons of mass destruction, preventing state-sponsored terrorism, regime change, the freeing of the Iraqi people, etc., it is increasingly evident that there is a much larger plan at play. Recent rhetoric suggests that once America succeeds in replacing the Iraqi regime, its focus will turn on other countries in the region. It’s astonishing that without even pausing for breath, once the Iraqi regime fell, Administration attack-dogs Rumsfeld and Wolfowitz started accusing Syria with the whole terrorism/sponsorship/WMD thing.

Iran may be next, and eventually even old friends like Saudi Arabia may find themselves in need of an unsolicited American- sponsored regime change. Also lurking and simmering in the background is North Korea, which is preparing itself for some type of confrontation with the U.S. Unless it can negotiate a non-aggression pact (something a recently battle-victorious U.S. is unlikely to give), it will continue to play its nuclear hand.

How Iraq’s Arab neighbors react to all of this is hard to predict. For one, they certainly don’t trust America’s motives and their rulers haven’t done much to prevent recent public outrage over America’s attack on Iraq out of fear their citizens will turn on them and partially to take the heat off how badly they have run their own countries.

Ironically, many of the Arab countries are run by regimes which would be deemed illegitimate by American standards but who, nonetheless, are propped up by the Americans. In the end, the rulers of these countries will likely keep a fairly low profile while quietly rooting the U.S.’s occasional stumble. Their enraged citizens, on the other hand, may eventually behave less predictably and this is when the entire region may turn into hell on earth. If at that point the Americans are still in the region, it will become a bloody conflict beyond what America is prepared for.

The “Liberation” of Iraq: America Will Be Less Happy

It is doubtful that the average American will choose to sacrifice his standard of living once the combined economic reality of the accumulated excesses and the costs of American foreign policy collide. Sentiment will eventually parallel that of the Vietnam era rather than say, WWII. Waging wars in far off lands that pose no “immediate threat” while impairing the comforts of daily life at home, have never succeeded in popularity for long. I am not sure what will happen at that point, but suffice to say, that America will be a less happy place to live in.

The debate over current U.S. foreign policy will continue. I will leave it to future historians to judge whether America was acting in self defense and for the benefit of the oppressed in need of freedom, or whether it was acting out of economic self-interest. I will say though, that, “freeing the world from evil” might be a long and expensive exercise. For the purpose of this analysis, it only matters how much this current adventurism will cost the U.S. economy and how the rest of the world perceives Americas intentions. The magnitude of the economic costs will negatively impact the U.S. dollar and foreign perception may amplify its fall.

In the long run imperialism and over-consumption are a recipe for economic decline. We only need to look back at the 16th century Spaniards, the late 18th – early 19th century French or the late 19th century – early 20th century British for historic examples of countries trying to run concurrent war- monging and consumption.

Of the three, the experience of the 16th century Spaniards makes for the best comparison with the Americans of today. For nearly 100 years immense supplies of gold and silver (the likes of which Europe had never seen before), plundered from the natives of Central and South America flowed into Spanish coffers. Sadly, this 16th century version of excessive money supply growth managed only to fuel the nations’ spending habits, while at the same time disincentivizing their willingness to produce. Instead of turning this windfall into productive wealth, Spain used it to buy “consumer goods” from other nations. As a result, Spain’s debt to foreigners soared and all the gold and silver was exported out of the country (think current account deficit without the ability to “print” more gold).

The “Liberation” of Iraq: The Holy Roman Emperor

With all this newfound wealth, it didn’t take long for the kings of Spain to think themselves superior and embark on a mission of bending the world to their will. Charles V, not satisfied any longer with being a mere king, lobbied intensely, using bribes and threats and eventually convinced a “coalition of the willing” to make him emperor of the Holy Roman Empire. After loosing quite a few of its booty-laden ships on the high seas, Spain, claiming self defense, declared that it would no longer make a distinction between the pirates and the nations that harboured them. To eliminate this “state- sponsored piracy”, they decided to strike at the worst offender – Britain (although I doubt that Philip II ever suggested that he was merely trying to free the British people from oppression).

Boasting their technologically superior Spanish Armada (not dissimilar to America’s air supremacy), they waged what proved to be a disastrous war against Britain whose smaller ships proved far too wily. Years of wars ensued with a variety of other countries that did not share Spain’s view of the world. Having already traded their gold and silver for consumer goods, the nation had to turn to debt-finance to pay for these wars. As Spain’s tab reached the limit, their lenders, the Fuggers of Augsburg (16th century version of the Japanese) were forced to convert their debt into long-term loans.

Eventually, Spain’s creditors cut them off and the nation, now bankrupt, introduced to the world the now time-honored tradition of default by a sovereign state.

Of course, in their time very few of the above mentioned governments or their citizens would have ever believed such an economic fate would befall them. I suspect most Americans today wouldn’t either. Truly amazing when one looks at the current sad state of America’s public and private balance sheet and its voracious consumption appetite. For although past global powers had their excesses, it took the Americans to really put the “pro” in the term profligate.

So what has all this to do with the price of gold?

The current economic and geopolitical direction of the U.S. will, unless corrected, lead to a long-term decline in America’s standard of living. How quickly all of this unfolds is subject to many unpredictable factors. There exists a small chance that this decline can be prevented, but that would take political courage and economic sacrifice that just doesn’t seem to exist anymore.

It may take several decades for the collapse of the U.S. financial system to occur or it could happen this decade. In a few years we may witness a new bull market in equities (although I doubt it) after this current bear market plays out. That said, the current macro-economic trend and its eventual outcome is undeniable.

The “Liberation” of Iraq: Dangerously Awash in US Dollars

Regardless how it plays out, there is one thing for sure. The world is dangerously awash with U.S. dollars. In addition to the previously mentioned levels of foreign owned U.S. debt and equities, it’s notable that more than three quarters of global central bank reserves are in U.S. dollars. The downward trend in the dollar began two years ago and is very much intact. Although it has fallen approximately 25% against the U.S. dollar index, it is still over valued and will most likely fall a further 15% in the next two years alone. In the long run it may go down a lot further. This bodes well for gold for several reasons. Firstly, as gold is priced in U.S. dollars, the dollar’s decline will make it cheaper to purchase in other currency terms and less attractive for non-U.S. gold producers to produce.

More importantly, if its imperial status is severely challenged and no other currency emerges as a viable alternative (only two are sizeable enough, the Euro and the Yen, and both have more than their share of problems), then gold will regain its historical status as the currency of last resort and the ultimate store of wealth. In this scenario, the price of gold would reach levels never seen before.

Unfortunately, it seems most Americans are impervious to the current economic trend, foolishly ignoring 2,500 years of monetary history. A history which is littered with lessons about the consequences of virtually every monetary and financial phenomenon we are witnessing today. Excess debt and consumption brought down every major power in history. Stock market and other asset bubbles, whether they were speculative manias (the tulip bubble of the1600’s), market frauds (the South Sea bubble of 1720), easy money bubbles (the Mississippi Company of 1721), or bubbles caused by innovations (the canals bubble of 1837 and the railroad bubble of 1873), all ended with crashes and subsequent depressions.

We are all familiar with the economic aftermaths of the 1929 stock market crash and the more recent 1989 Japanese stock market and real estate crash. Finally, “preemptive” wars and other types of military adventurism are also nothing new and the end result in economic terms is never very pretty.

The “Liberation” of Iraqe: Inevitable Debasement of Currency

Inevitably, a combination of these events is almost always followed by subsequent currency debasements (as invented by Dionysius of Syracuse in 400 BC and practiced regularly by every major world power since, especially with the introduction of paper money).

America will be no different.

It’s only a question of time. Since none of us knows how long before that day comes, I suggest that at the very least investors should diversify out of U.S. dollars and hedge their portfolios with at least 15% gold content.

As for the lesson in this story, unfortunately it will be learned time and time again throughout history and our protagonist, gold, will always be around to provide refuge from man’s inherent need to push things too far.

Finally, for those that read this and dismiss it as apocalyptic ramblings, consider that all I predict is a repetition of history, not the end of it. The day will come when it will be prudent to sell one’s gold holdings and invest in paper assets. Furthermore, although corporate America may be in decline, investment opportunities will always exist. And if not in America, then in other parts of the world, perhaps in emerging economic powerhouses such as China.

On the bright side, who knows, perhaps in 50-100 years, it will be the Chinese who will play the “Ugly” role in our movie.


Frank Giustra,
for The Daily Reckoning
May 28, 2003

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Expecting deflation is “no longer a kooky point of view,” Ray Dalio tells us (in USA Today).

We are so glad to hear it; we had begun worrying about ourselves.

But while USA Today reassures us that the opinion is no longer “kooky,” it is still very, very unlikely. The IMF says so. So does everyone else.

But last week, by pure accident, America’s beloved central banker, Alan Greenspan, told us why they all may be wrong. His intended point was preposterous — that central banks “essentially have restrained the expansion of credit enough that many aspects of the gold standard, which induced deflationary patterns in past periods, have been replicated in our monetary systems.”

Of course, central banks have done no such thing.

The Fed let loose a torrent of credit that now sits in huge, stagnant puddles all over the world. And yet, the world is beginning to act as if there were, in fact, a gold standard in place; many prices are falling, just as they did in the 1880s and in the 1930s. Central banks all over the world stand ready and willing to provide more cash and credit (the European Central Bank will probably cut rates at any moment) and still the world economy slumps.

What we are seeing is the deflation of the huge bubble created in the last 3 decades of the 20th century. Central bankers could do away with the Gold Standard…but they couldn’t do away with the problems the gold standard helped to solve. Once gold was out of the way in 1971, the Dollar Standard made it possible for the U.S. to expand the world’s supply of money and credit far beyond anything the Gold Standard would have permitted. But it could not go on forever. Under the Gold Standard or the Dollar Standard every credit carries a debit on its back… a burden that gets heavier and less portable as the amount of credit expands.

It took years to puff out the U.S. dollar credit bubble; now it is taking years to deflate.

“The high level of the dollar has been another manifestation of the remains of the ‘bubble mentality’ in financial markets,” explains Tim Lee in the Financial Times. “The US economy’s apparent resilience has, in large part, been due to the Fed’s monetary policy aggressiveness. At other times, or in other countries facing similar circumstances, the monetary policy that has been implemented by the Fed would have been impossible. The combination of monetary laxity and weak growth, against the background of the large imbalances, would have resulted in currency collapse. The Fed has got away with it up to now because of the financial markets’ irrational attachment to the dollar, helped out both by the Asian central banks’ willingness to accumulate dollar reserves and by US fiscal policy.

“These factors could not have supported the dollar indefinitely. Investors should now be prepared for the dollar’s fall to go much further than they might have thought possible.”

How far could it go? We do not know. We cringe and wait to find out.

Now, over to our New York colleague, Eric Fry:


Eric Fry writing from Wall Street…

– The recession is over, and so is the bear market in stocks…or so the financial markets seemed to proclaim yesterday. Stocks rocketed higher, while bonds plummeted…just like what happens during a REAL economic recovery! The Dow rallied 179 points to 8,781, while the Nasdaq Composite jumped more than 3% to 1,556.

– The bond market answered the stock market, downtick-for- uptick. The benchmark 10-year Treasury note dipped 21/32, to drive its yield up to 3.41% from 3.34% on Friday. The 30-year bond suffered an even heavier selling barrage, as its yield spiked to 4.38% from 4.26% on Friday.

– Animating both the stock and bond markets — albeit in opposite directions — was the news that consumers are feeling a bit better about things, and that they are putting their money where their feelings are by buying houses…lots of houses.

– Consumer confidence rose to a six-month high of 83.8 in May from April’s 81 — the highest level since November.

– Tellingly, however, consumers are far more sanguine about the future than they are about the present…which may help to explain the source of the current, hope-infused rally in the stock market. The current conditions component of the index deteriorated to 67.9 from 75.2. But, hold onto your hats, the future expectations component soared to 94.4 from 84.8. What’s more, the expectations index has risen by 33 points in the past two months.

– Indicative of the resurgent confidence, many consumers are availing themselves of generation-low interest rates to buy houses, and your New York editor doesn’t blame them one bit. Why not take advantage of the bond bubble to take a flyer on the housing bubble? Single-family home sales jumped 1.7% in April, their fastest pace of the year. Existing home sales jumped an even more stupendous 5.6%.

– As bubbles go, the housing bubble hardly compares to the bond bubble. Therefore, borrowing long-term at 5% to buy a house may not be the world’s worst investment. In fact, borrowing at low fixed rates to buy a house amounts to a sort of “Texas hedge” against inflation. (A Texas hedge is when an investor makes two separate investments that are certain to succeed or fail together. Like, for example, buying gold AND gold stocks). If inflation returns, the nominal price of houses is likely to rise, even if inflation erodes some or all of that gain.

– Of course, if Greenspan’s deflationary angst proves to be justified and deflation grips the land, borrowing to buy a house could turn out to be one of the worst investment ideas of this generation…Place you bets.

– Here in New York, we remain friendly to the idea that a new inflationary episode is not impossible. Perhaps that’s because evidence of inflation is so visible. “The New York papers are full of details of what a layman might describe as an unwelcome, substantial rise in inflation,” writes Jim Grant in a recent Forbes column. “Recent or impending jumps in rents, subway fares, bridge tolls, property taxes, income taxes and cigarette taxes have contributed to the growing apprehension that one day soon the only New York resident who will be able to afford to remain in the city is Michael R. Bloomberg, its billionaire mayor.”

– Grant reckons that resurgent inflation is not an impossibility, thanks in part to the Fed’s promise to fight deflation.

– “Sufferers in the great inflation of the 1970s may have doubted they would ever live to see the day, but the day is here,” Grant writes. “On May 6 the policy-making arm of the Federal Reserve declared that the rate of inflation is worrisomely, almost unacceptably, low. The Fed indicated it wouldn’t stand for it. – “You may now be rubbing your eyes. The Fed is purportedly in the business of making prices ‘stable.’ But now that prices are virtually stable, the Fed is worried they might sag. The Bank of Greenspan may not want a lot of inflation. However, it wants even less to have no inflation.”


Bill Bonner back in Baltimore…

*** rose to a 52-week high. Ha ha ha ha…

[Although, having said that, we’re happy to see our friend Jim Rogers’ new book Adventure Capitalist is #1 on the Amazon finance list. If you haven’t seen it yet, I recommend you take a look:Adventure Capitalist – highly recommended reading!]

*** Gold dipped $1. The dollar slipped further against the yen.

*** Freddie Mac reported record low mortgage rates of 5.34%. A one-year adjustable rate of 3.61% is also available. *** “The world’s only superpower is turning into a banana republic,” wrote the New York Times’ economist, Paul Krugman, recently. He was referring to the enormous debts and deficits being run up by the current administration. Krugman has come to a conclusion about the Bush administration:

“The people now running America aren’t conservatives, they’re radicals who want to do away with the social and economic system we have… “

We don’t know if the Bush team want to change the system radically, but they are certainly the most activist bunch of conservatives we have ever seen. They seem to think they really know what is best for the world and are going to make sure we get it, good and hard.

But the more often we visit Nicaragua the more we begin to think that turning into a banana republic wouldn’t be so bad. The weather is nice. The fruit is fresh. And the cost of living is low. Besides, people take their politicians less serious; they seem to expect them to act like clowns, crooks and desperadoes. They suffer few disappointments.

Your editor went into a barbershop to get his hair cut. The woman barber seemed to enjoy her work, smiling coyly as she clipped and shaved. And, then almost reluctant to let her client go, so gently did she massage and caress his benuded head that he drifted into sweet afternoon reverie. He saw himself dressed standing on a balcony of a large building on the public square. Dressed in a gaudy uniform, he was delivering a fiery speech….full of sturm and drang…but with jolly asides…ironic twists and tear-stained public confessions. It was a real barn-burner of a speech, worthy of a demented TV evangelist. But then, looking out on the crowd gathered in the plaza, he realized that there was something wrong. The people stood and stared at him. But they were not moved, only puzzled. Alas, he was giving his speech in the wrong language.

What’s wrong in his cabeza, the crowd wanted to know. Your editor awoke with a disappointed start. He gave the barberessa $2 and got change.