Gold v. the Dollar

It is difficult to argue with gold.

To men everywhere, gold is a desirable economic object. It can be used for the manufacture of jewelry and ornaments. It is a corrosion-resistant element, the most malleable and ductile metal, ideal for plated coating on a wide variety of electrical and mechanical products. It is a good thermal and electrical conductor. It is durable and storable, can be easily hidden from partakers and predators, and readily shipped to other places. Gold is very marketable. In fact, gold may be the most marketable commodity around the globe.

The value of gold is determined by the same considerations as that of all other economic goods. Individuals give it value according to the enjoyment and satisfaction they expect to get from its possession. Economists explain this fact in terms of utility and scarcity. Value rises or falls in accordance with the utility which people ascribe to an object and the scarcity they perceive. Like that of any other economic good, the value of gold changes according to changing perceptions and situations.

This must be emphasized because there are many goldphiles who wax eloquent about the eternal, immovable value of gold. They obviously have never experienced, and cannot think of, a situation in which basic essentials that sustain or safeguard human life do soar in value while that of gold in any form plummets. In fact, in desperate situations, people may prefer a pound of bread to an ounce of gold, essential clothing and shelter to a pound of gold and, when their lives are at risk, their lives to a ton of gold.

Budget Deficits: Plentiful Gold

The supply of gold is plentiful. For thousands of years it has been mined and accumulated; very little is consumed or lost. Existing supplies in the form of coins, jewelry, decoration, and plated coating are greater by far than current production. No matter how much gold is produced in South Africa or Russia, current output is rather negligible when compared to the quantities in individual possession throughout the world. This characteristic, in which it differs from all other metals, reduces the risk of sudden changes in quantity and, therefore, sudden changes in its value. Even silver, which has many characteristics similar to those of gold, is subject to great changes in production and consumption that may affect its value.

The special characteristics man ascribes to gold have made it the most marketable economic good of all, the popular medium of exchange and unit of economic calculation and account; they have made it man’s money. For more than 2500 years, from ancient Greece to modern USA, gold coins have served as money and the standard of calculation and account.

Throughout the ages governments have had a love-hate relationship with gold. Most of the time, they sought to amass it in their treasuries and monopolize its use. They claimed and brutally enforced a monopoly of the mint. At other times governments waged war on gold, seeking to ban it under penalty of fine, imprisonment, or even death. During the French Revolution, hundreds of businessmen died on the guillotine because they had dared to calculate prices in gold or ask for gold. In the United States, from 1933 to 1975, it was a crime punishable by fine and imprisonment to own standard gold coins. At present, the U.S. government, while clinging to a sizeable hoard buried in Fort Knox, seeks to disparage it and make little of it as an unimportant metal.

We are living in an age in which all governments, regardless of the system of political and economic organization, whether interventionistic, socialistic, democratic or dictatorial, are occupying an economic command post. Most of them work through central banks issuing legal-tender notes and through government mints manufacturing coins. In 1971, they suspended gold payments and made the most important and most stable currency – the U.S. dollar – take the place of gold. The world has been on a dollar standard ever since.

Budget Deficits: Cheerful Spending

For the US federal government the dollar standard has been a magical guide to cheerful spending and soaring debt. It released the Federal Reserve System from the shackles of gold and set it free to finance federal deficits no matter how large. In 1971, the federal government deficit amounted to $23.033 billion, and the federal debt stood at $409.5 billion.

By now, the 2003-2004 federal budget calls for expenditures in excess of $2.1 trillion and a debt of some $7 trillion. Since 1971, the American dollar has lost almost 70 percent of its purchasing power and is losing more every day. It makes it difficult to project future debts and deficits, but it is likely that the dollar standard will disintegrate if foreign investors should ever lose their confidence in it.

For the American people, the world dollar standard has been, and continues to be, both a welcome boon and a dreaded affliction. It is pleasant and beneficial as it permits the Federal Reserve System to engage in massive credit creation that generates unprecedented trade deficits, now running at a rate of over half a trillion dollars a year. At some five percent of gross national product (GNP), the trade deficits actually have lifted the levels of consumption of the American people, while they depressed the levels in creditor countries. Moreover, the dollar standard has enabled the U.S. Treasury to place much of its new debt with foreign investors and thereby shift much of the burden of debt to foreigners.

The dollar standard has also been a dreaded affliction, as it allowed the Fed to depreciate the American dollar every year and finance a frightful expansion of government functions and powers. Dollar savings have lost some 70 percent of purchasing power, while the number of government rules and regulations probably has risen by a similar proportion.

Many economists are convinced that the current pattern of Treasury deficits and Federal Reserve money and credit expansion is not sustainable. They call for large tax increases or drastic spending cuts that would allow the Federal Reserve to decelerate its money fabrication. But they also are aware that large tax increases at this time of economic stagnation and rising unemployment would depress economic activity even further. Spending cuts, on the other hand, probably would bring relief to the ailing economy, but undoubtedly would be unacceptable to the political forces that benefit from the spending. They usually cite old notions and theories that advocate deficit spending as a panacea for economic evils and difficulties.

Budget Deficits: A Possible Crisis of Confidence

The huge budget deficits may yet be solved in another way: the Federal Reserve may continue to cover them with new money and credit, which may depreciate all dollar debt as fast or faster than it can be added. A five-percent inflation depreciates the purchasing power of a $7 trillion federal debt by $350 billion a year. At the 1980 rate of inflation of 12.5 percent, the federal debt would shrink by $875 billion in purchasing power, and at the 1990 rate of inflation of just 6.1 percent, by $427 billion. But such a solution may cause a crisis of confidence in the integrity of the American dollar and precipitate the end of the dollar standard.

For most of a generation, the almighty dollar has been a great object of confidence and trust throughout the world. It brought honor, friends, influence, and possessions to the United States. As a symbol of power and prestige, it answered all things. Although we do not know what the future has in store for us, we are fearful that the age of the world dollar standard may some day draw to a close. Huge federal government deficits and chronic Federal Reserve inflation may destroy it. The deficits force the Fed to generate ever more money and credit, which in turn weaken and erode the dollar’s trustworthiness in the eyes of the world. Its present weakness toward many other currencies, such as the euro, the Swiss franc, and the British pound, is an early symptom of the erosion.

No other currency, national or international, can conceivably take the place of the American dollar. They all suffer seriously from the same ideological malady: they are the creation of political concern and authority. Whatever we may think of gold, it always looms in the background, beckoning to be used as money, as it has been since the dawn of civilization.


Hans Sennholz,
for The Daily Reckoning
March 19, 2003


Give war a chance.

Stocks rose again yesterday, anticipating the sound of cannons by perhaps only a few hours. Investors expect a neat little guerre, one with few American body bags, few complications and few surprises.

What was supposed to have been a post-war rally has become a pre-war rally. What will happen when the war is over? Will the pre-war rally turn into a post-war bust?

All we can say with any assurance is that there will soon be a big boom in Baghdad. Lots of them. Whether they will do investors any good is an open question.

The world is full of question marks.

Suppose the war is short and sweet. And suppose it is followed by a bull market on Wall Street, a boom in the economy, and George W. Bush’s reelection. Will that be a good thing? Or would it be only a prelude to an even bigger disaster – as the bear market of 2000 – ? (another question mark!) inevitably grinds down towards its eventual bottom. Whoever heard of a bear market bottom at 40 times core earnings? Somehow, sometime, stocks have to go lower…wouldn’t putting it off just make it worse?

But what if the war appears to have done great things for the economy? If a little war produces such agreeable results, who would say ‘no’ to a big one? Wouldn’t it turn the next wheel on the Axel of Evil into an irresistible target?

That is the problem with history, dear reader; it is always more complicated, more perverse, and full of more surprises than people want to think about.

In a bull market, the question marks disappear. Investors stop asking about funding pensions, stock options, executive compensation, P/E ratios, and ‘pro-forma’ earnings. They stop worrying about earnings all together. All that matters is that they are ‘in the market’. Because, as everyone thinks he knows at the top of a bull market, nothing beats buying and holding stocks.

Later, stocks come down, and the question marks come out.

“What was I thinking?” becomes a common point of interrogation. “I wasn’t thinking at all,” is the answer most often given.

In today’s financial markets, the question marks are only beginning to appear. Most people still believe in ‘stocks for the long haul’. But after three years of negative returns, they’re beginning to wonder how long the long haul will be.

Meanwhile, it is still a bull market in U.S. power. And in the group-think of politics, question marks are as scarce as tourists in downtown Basra. People would prefer to avoid niggling doubts and annoying arrière pensées. In fact, judging from the hundreds of email messages arriving here at the Daily Reckoning every day, there are a fair number of readers who are downright sick of our quibbles. In their minds, the situation is simple: there is Evil on one side and Good on the other.

Tomorrow night, or thereabouts, the forces of Good are expected to confront the forces of Evil…and bomb the hell out of them. Then, the world will be a better place.

We hope they are right. But quibbling and question marks are what you don’t pay us for, dear reader. More below…after Eric’s report:


Eric Fry in New York…

– The lumpeninvestoriat continued snapping up richly priced stocks yesterday. The Dow jumped 52 points to 8,194, while the Nasdaq advanced half a percent to 1,400. Gold for April delivery added 50 cents to $337.70. Yesterday’s eager stock buyers understand that bombs are bullish, especially when the bombs fall on distant countries with feeble armies. Only numbskulls worry about rich stock market valuations or deteriorating economic trends.

– U.S. housing starts fell 11% in February from January’s pace, the biggest percentage decline in nine years. But why worry about such minutia when bombs will soon be falling on Iraq in the largest quantities in 12 years?…Just imagine how the bombing will boost housing starts in Baghdad later this year!

– The flip side of this week’s paradoxical stock market rally is the paradoxical crude oil sell-off. Oil traders seem to have determined that the imminent invasion of a major oil-producing country is, somehow, bearish for oil prices. Crude oil for April delivery tumbled $3.26 to $31.67 a barrel yesterday.

– Speaking of paradoxical, who keeps buying all of our bonds?…Compared to buying a stock at 30 times earnings, buying a long-term bond yielding less than 4% might seem like a lower risk proposition. Then again, compared to jumping out of an airplane without a parachute, jumping out of a 5-story window might seem like a lower-risk proposition…but the outcomes would not be dissimilar.

– The fact is, investors needn’t buy either expensive stocks or expensive bonds. As Warren Buffet recently remarked, “Occasionally, successful investing requires inactivity.” Cash is not trash when the alternatives are fraught with risk. Nevertheless, many investors tend toward hyperactivity, feeling the need to do SOMETHING at all times. How else does one explain the strong demand for low- yielding bonds?

– “I cannot see a reason to buy anything other than government bonds,” a Mr. Kornelius Purps, fixed-income analyst at HVB Group in Munich, declared to Bloomberg News recently. We do not know Mr. Purps personally. But the man seems to lack imagination. We can think of many reasons why an investor might want to avoid Uncle Sam’s IOUs, miserly yields being only the most obvious reason. 10-year Treasury note yields have tumbled to 3.90%, the lowest since the Eisenhower Administration.

– A paltry yield on a long-term bond creates what professional investors refer to as “asymmetrical risk”. In other words, many things must go right for the investment to work out well. But very little has to go wrong for the investment to work out badly.

– Another reason why an investor might not want to put every egg he’s got into the low-yielding-bond basket is that bond issuance is soaring. The Federal government – along with many state and local governments across our fair land – is ramping up its borrowing. And that means there will be plenty of bonds to go around.

– Several years ago, a cartoon on the cover of Grant’s Interest Rate Observer depicted a man bolting upright in his bed with beads of sweat flying off his brow, as if awakening from a nightmare. The caption read, “I dreamed they ran out of bonds!”

– Many of today’s bond buyers seem to possess a similarly irrational fear of a bond shortage. But investors needn’t lose sleep over that possibility. The Federal Government’s growing budget deficit will insure a steady supply of bonds. And the state governments will also do their share to make sure that each and every citizen who wishes to buy a bond will be able to do so.

– “State and local governments tapped the municipal bond market for cash at a faster clip in the first two months of 2003 than they did a year ago,” Dow Jones News reports. “Long-term borrowings in January and February tallied an unprecedented $52.3 billion, up 22.8% from $42.6 billion in the year-earlier period.”

– So why do yields keep falling, even though supply is rising? Two words: fear and foreigners. – Fearing additional losses in the stock market, individual investors have been dumping stock mutual funds for the last several months and rolling the proceeds into bond funds. Merrill Lynch estimates that households were net sellers of $466 million of U.S. equity funds in January and net buyers of $12.7 billion of bond funds. The trend continued in February. But individual investors are not the only ones lining up to buy bonds. Foreigners have been big buyers of government bonds as well. – “Rest of World [i.e. foreign] acquisition of U.S. credit market instruments surged last year to $416.9 billion,” the Prudent Bear’s Doug Noland explains. “This compares to 2001’s $320.6 billion…The day our foreign-sourced financiers move to liquidate U.S. securities, we are faced with a calamitous dislocation.”

– The good news is that calamitous dislocations don’t come along that often.


Back in the land of croissants and quibbles…

*** The bull/bear cycle in a stock market over-rides logic and reason. A dollar’s worth of earnings is thought to be worth only $8 at the bottom of the cycle…and as much as $200 at the top. From fear to greed…from confidence to desperation…markets run their course.

And who are we to argue with it? If that is the way the gods want it, well…so be it. We’ll just try to enjoy it.

*** But what happens in politics? If our view is correct – that bubblish sentiments have leaked from the financial markets in America into geo-politics – mustn’t the same cycle run its course, no matter what we or anyone else says?

We don’t know, of course. But history is full of examples of politics run amok. People rarely seem to come to their senses. Instead, bubbles continue to expand until some sharp object comes along to prick them. Then, they continue to deflate until they are flattened.

*** Few investors have noticed, but the dollar’s edges have become razor sharp.

Thanks to the cost of its wars on terror and Iraq, the federal budget deficit, says Bill Gross, is expected to come to between $400 and $500 billion “as far as the eye can see”. Most of this is in addition to the current account deficit – now running about $500 billion. Together, this leaves the U.S. with about $1 trillion per year in financing needs.

Already, 80% of the world’s savings are spent by Americans. Maybe, in the post-war era, the world will want Americans to spend even more of its savings. Then again, maybe it won’t.

*** If foreigners do not willingly lend the money, how will America finance its new industry – exporting ‘security?’ We ask the question without prejudice or malice. We just want to know. Successful or not, someone will have to pay for it. And we have a sneaking suspicion that the answer will be the key to the world’s investment markets for the next several years: either Bernanke & Co. will really manage to inflate the dollar – putting the costs on the creditor class (35% of U.S. Treasury bonds are owned by foreigners) – or the weight of debt will collapse the economy and the markets. Argentina or Japan, in other words.

*** “Gloom for world economy” following the war, predicts a BBC report. The head of the IMF thinks American deficits, combined with recession and stagflation in Europe, will be fatal. But, of course, he doesn’t know any more than anyone else. And in this new Information Age, with around-the- clock news available to everyone…we are all ignorami, now. You may quote us on that.

*** It is a bright, beautiful day in Paris this morning. The outdoor cafes are already starting to fill up. Lovers stroll in one another’s arms. The smell of pain au chocolat drifts up from the bakery. What a pretty day for a war.

The frogs do not seem to be worried about tomorrow’s war… but they are proud not be a part of it. Today’s LIBERATION even suggests that President Chirac may be a candidate for a Nobel Peace Prize, thanks to his determined stance against the war.

Contrary to what our critics may think, we have no illusions about Chirac. While we’ve never met the man, we have no reason to think he is any wiser…or any more honorable…than, say, George W. Bush! A pox on both of them…

There, we’ve managed to insult our American readers and our French readers at the same time. Bravo for us…

…so go ahead. Cancel your subscription!

The Daily Reckoning