The Golden Road

In 1992, the Brazilian economy buckled under debt and runaway inflation, resulting in a complete collapse of the Brazilian real. The real literally went to zero and was replaced with the new real.

During crises, money flees to the safest haven. The Brazilian crisis caused large amounts of capital to seek asylum in the U.S.. Careful analysis shows that the influx of capital from Brazil caused a noticeable uptick (about a 10% gain) in the U.S. dollar from 1992 to 1994. This marked the beginning of the greatest bull market in history, encompassing stocks, bonds and real estate.

The next year, 1995, Mexico experienced its biggest economic collapse since the Revolution and the peso lost 50% of its value. Being our southern neighbor and one of our largest trading partners, this caused additional capital to flee to the U.S., which in turn strengthened the dollar even more. Our stock and bond markets followed suit.

The Rebirth of Gold: Migrating Capital

At this stage, the U.S. economy was robust, real interest rates were running at 5.02% compared to Europe’s 3%, and given a stronger economy and higher real rates of return, it is no surprise that capital migrated to the U.S. as economic mayhem continued to plague the world. But the stock market was already overvalued, with the Dow at around 3,500.

In 1996, the South East Asian Tigers caught a bad case of the flu. This time, however, the new capital influx into the U.S. was staggering, totaling $356 billion during 1996 and 1997 alone. It is not a coincidence that gold peaked in February 1996 at $415 an ounce.

The world was still sniffling from the Asian Flu when Russia defaulted on its debt in 1998. In January 1999, the euro was launched and promptly started falling against the dollar, eventually losing as much as 35% during the ensuing two years. More capital made its way into the U.S. attracted by reports of a “New Era”, supposedly as a result of productivity gains and the ultra-efficient U.S. economy. Not to mention the gains in the U.S. stock market from earlier flight capital infusions…and of course there was still the perception of the U.S. as a safe haven for foreign capital. By this time, it was already difficult to distinguish between the roaring 20’s and the roaring 90’s.

From 1992 to 1999, more than $1.2 trillion (net) flowed into the U.S. economy. This had to have ramifications. Initially, the money was invested primarily in bonds, leading to a spectacular bull market in that sector, but more importantly driving down U.S. interest rates.

The Rebirth of Gold: The Effect on the Market

The falling cost of capital had an immediate effect on the U.S. economy and the markets. Lower borrowing costs increased corporate cash flows and profits. Higher profits lead to higher stock prices as more cash flow allowed companies to increase capital expenditures and R&D. The latter two stimulated the economy by increasing jobs and the velocity of money in the system.

Individual consumers also benefited. Unemployment declined, along with mortgage rates and the interest on bank loans. Cheap access to money induced both corporations and consumers alike to take on debt at a staggering pace. From 1992 to 2002, consumer credit increased 119% and corporate debt 95%.

It’s important to realize that Bill Clinton and Alan Greenspan did not engineer these ‘good times’. They were merely bystanders, spectators and orators. The markets did not listen to Greenspan in 1996 when he warned of irrational exuberance because he could not stem the influx of capital. Likewise, Greenspan will not be able to alleviate the correction we are now experiencing any more than he succeeded in having preventing it. Finally, the emperor is seen for what he is.

As mentioned, the dollar’s run started in 1992, but it was not until 1996 that it really got going. And the stronger dollar had consequences. Exports from the U.S. become more expensive, hurting the export industries. Imports get cheaper, hurting those competing with lower prices (imported products, as in the steel industry). Lower import prices also stimulated demand for imported goods, causing the balance of trade to get out of kilter. A negative $36 billion trade balance in 1992 expanded to over $420 billion by 2002.

The Rebirth of Gold: Two Sides of the Same Coin

Undeniably, a negative trade balance leads to a negative balance of payments. The influx of capital during the 1990’s and the expanding trade deficit are two sides of the same coin. Foreign demand for dollars was offset by out demand for imported goods.

The problem with an expanding negative balance of payments is that never before in the history of the world has there been a large balance of payments deficit that was not followed by a recession to correct the imbalance. The magnitude of the ensuing recession is also in direct proportion to the size of the deficit. The problem is that the balance of payment deficit in the United States today is exceptionally large by any measure. On a nominal basis, it is the largest the world has ever seen.

The magnitude of our balance of payments deficit suggests that we are going to have a long and severe correction ahead of us. The influx of capital into the U.S., which lowered our borrowing costs and led to exorbitant capital expenditures, suggests that we are not merely looking at a recession, but a full-blown depression.

Regards,

Paul van Eeden,
for the Daily Reckoning
February 20, 2003

P.S. Foreign capital has not yet left the U.S. en masse, as evidenced by our still negative balance of payments. But it is becoming ever more difficult to attract new foreign capital on economic and investment merits. Bush is not helping, either, by changing the previously favorable U.S. climate for foreign capital to a perilous one with terrorism-related seizures and the freezing of accounts.

The U.S. economy is stumbling over a cliff, and it’s going to take the dollar with it. The result will be slower, or negative, economic growth, collapsing stock and real estate markets, and spectacular bankruptcies.

This collapse in asset prices creates deflationary pressure that the Fed is going to fight tooth and nail with as much money creation as possible. That will ultimately lead to a real inflationary problem that could be far worse than anyone is currently imagining. Navigating through this investment environment will not be easy.

P.P.S. Fortunately, there is hope. The future is bleak for the dollar whether we face inflation of deflation. That is because during the current deflationary period, U.S. economic growth is grinding to a halt, thereby reducing the allure of U.S. stocks, bonds and real estate to foreign investors. As foreign investors reduce their investment in the U.S., the dollar will fall. To combat deflation, the Fed is going to try to devalue the dollar, which is obviously bad for the dollar.

Since gold acts as a stable international monetary asset and since the gold price in U.S. dollars is inversely proportional to the U.S. dollar exchange rate, the gold price will increase as the dollar falls.

Furthermore, war games around the world are likely to cause the average gold price to increase as well, further increasing the U.S. dollar gold price. The question should not be whether to own gold or not, but how to invest in gold and related assets.

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Did the war against Iraq begin yet? Have investors panicked? Has a new bull market begun?

Your editor just returned from a 10-day vacation in Nicaragua where his internet connection would not work. If something really important happened, he reasoned, the news would eventually penetrate the Latin American isthmus and find him at his tranquil outpost on the coast. But no news disturbed his peace. No newspapers distracted his thoughts. No TV nor internet persuaded his attention away from the paradise before his very eyes. Out in the wilderness, he knew not what happened in the world…and soon forgot to care.

But, now that he is back in the land of latte and nutrasweet, he turns to Addison for the latest market update:

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Addison Wiggin, reporting from, er, Baltimore…

– “Bulls holding steady”, a headline read briefly on the USAToday website this morning. Indeed, a late day rally saved all of the major indexes from greater declines. But when the snow was finally cleared and the shovels put away for the day, the Dow was still down 40 points, closing at 8000… giving back a skosch of the 291 points gained over the last two sessions.

– The Nasdaq gave up 12 points to close at 1334, and the S&P 500 surrendered 6.

– Chalk one up for the New York editors of the Daily Reckoning: Following a decline of 0.1% in December of last year, and not even two months after the infamous Bernanke speech, wholesale prices sustained the “worst inflation” in 13 years. The Producers Price Index (PPI), says a Bureau of be-Labored Statistics report released early this morning, jumped 1.6% in January, the largest increase since the concomitant month in 1990.

– If you’ve spent any time on the nation’s highways in the past month, it’s no secret what accounted for a healthy segment of the PPI increase: gasoline surged at the pumps in January. Heating oil rose significantly too, as cold winter months, particularly in the North East (thank you, very much) have put a strain on supplies. Oil, too, has been stretched – dropping to a 29-month low. Overall, energy prices jumped 4.8% for the month…and food prices rose 1.6%.

– And what’s this? Surprise, surprise. In addition to setting an historical record for all of 2002, the United States has now set an all-new monthly high for consuming the world’s capital. The trade imbalance reached $44.2 billion in December…up 10.5% from the previous record set a month before ($40.0 billion).

– For the year 2002, the Commerce Department reported this morning, the deficit shot up like a bull market stock index: up 21.5% from the $358.3 billion trade gap recorded in 2001. At $435.2 billion, the trade deficit for last year is the largest imbalance in history, blowing the old 2000 record deficit of $378.7 billion clean out of the water.

– And now, it looks like Americans are not only scarfing up the world’s capital, but its food, too. For the year, Americans bought more Cabernet, brie and barley than its farmers were able to sell abroad. Agricultural products, normally a healthy U.S. export, fell into deficit for only the second time on record.

– Faithful Daily Reckoning readers will not be surprised to learn that the U.S. ran up its largest inter-country deficit with China. Last year, Americans traded 103 billion pieces of its Monopoly script for a supposedly equivalent “value” of Chinese gee gaws. The year now marks the third straight one in which the U.S. has recorded its largest trade deficit with China…since pushing aside the former champion, Japan.

– One unseen, but significant, export from the U.S.: mortgage debt. According Robertson Morrow, writing in the American Conservative, nearly 20% of mortgage debt in the U.S. is securitized and sold to foreign investors – thereby inextricably linking two of the U.S. economy’s greatest and growing imbalances: mortgages and the trade balance.

– “An indispensable aspect of the debt binge is the willingness of foreigners to lend us the money,” says Morrow. “Not only is 20 percent of mortgage debt sold to foreign banks and other foreign buyers outright, but modern finance has made all liquid instruments de facto fungible. Even when foreigners buy other American financial assets, they are propping up a market of which mortgages are a part. Take the foreign buyers out of the equation and the whole thing collapses, and plentiful, cheap mortgage debt is no longer available to Americans.”

– “Without foreign buyers,” Morrow continues, “the wave of cash-out refinancing and home equity loans would reverse, and we would return to the normal mode of gradually paying down mortgages. The foreign-debt bubble, and therefore the mortgage bubble, is a necessary consequence of our trade deficits.”

For those cashing out the equity in their homes to buy foreign gee gaws, you might want to take note: the same crazy wave of financing that whipped its way through the Tech and Telecom craze and subsequently devastated your retirement fund…is now setting its course for your home.