The Building Storm: Gold, the Dollar and Inflation

One could hardly fail to notice that gold investors have suffered a little more than a “bit of pain” over the past month. More like a good kicking as gold moved down by about 20% from its recent high of $986 on July 15. David Galland of Casey Research explores…

Making assumptions is often a bad idea, but I am going to go out on a limb here and make the assumption that those of you with an interest in gold are concerned over the latest setback, the depth of which has surprised even us.

Don’t be.

The evidence to support that statement would fill a telephone book at this point. Starting with the latest U.S. inflation numbers which, even using the government’s own crooked calculations, rang in the last reporting period at 5.6%. Quoting John Williams of from a recent email I received from that organization…

“Reported consumer inflation continued to surge on both a monthly and annual basis, once again topping consensus expectations. The July CPI-U jumped to a 17-year high of 5.6% in July, while annual inflation for the narrower CPI-W – targeted at the wage-earners category where gasoline takes a bigger proportionate bite out of spending – annual inflation jumped to 6.2%. The CPI-W is used for making the annual cost of living adjustments to Social Security payments. The 2009 adjustment – based on the July to September 2008 period – remains a good bet to top 5%, more than double last year’s 2.3% adjustment for 2008. Such is not good news for federal budget deficit projections.”

Based on William’s calculations, which use the same CPI formula used by the Fed prior to the jiggering of the Clinton years, the actual inflation rate is now running at 13.64%. And on August 19, we learned that the U.S. Producer Price Index rang in at a month-over-month increase of 1.2%, the third month in a row where that leading indicator has topped the 1% mark. Meanwhile, in Europe, the latest numbers put inflation at a 16 year high. And these are not anomalies, but the norm as the inflation tide continues to rise literally around the world.

A good analogy to the global currency devaluation is a slow-moving hurricane that, once over warm water, gains energy.

Right now the global inflation is a huge storm, slowly circling off the proverbial coast where it is gathering strength from the hundreds of billions of dollars being fed into it by governments desperate to avoid economic collapse…and from pricing decisions being made by everyone from manufacturers to local shopkeepers looking to cover rising costs.

At this point the skies are dark, the wind is rising, and the torrential rains are beginning to sweep in. The radio is broadcasting warnings to move to higher ground, but the hurricane has yet to hit the shore.

But when it does, it will be a Category 5 and maybe worse.

That’s because, in addition to the straight-up consequences of the government monetary prolificacy and businesses raising prices to try and stay afloat, there is something else feeding power to the storm…something we have been warning about for years now: the rising odds that the global fiat currency system will fail.

Let me add some nuance to that remark.

In recent years, the global financial community, reflexively looking for an alternative to the obviously damaged U.S. dollar, has settled on the euro. But the euro is equally flawed, and maybe even more so, than the U.S. dollar. Now that the trading herd has also come to that conclusion, they are rushing back toward the dollar.

They are doing so not because the U.S. dollar is healthy, but rather because that is all that they know…a heads-or-tails continuum running something along the lines of “If the ‘it’s-not-the-dollar’ play is over, then it must be time to go back into the dollar.”  The euro sinks, the dollar goes up.

And so gold, viewed by these same traders only in terms of its inverse relationship to the dollar, gets hammered.

What they are missing, but not for much longer, is that rushing back into the dollar is akin to heading for the vulnerable coast, and not to the higher ground now proscribed. They are also missing the point that gold’s monetary value is not limited to protecting only against a failure in the U.S. dollar, but against any faltering fiat currency…a moniker that the euro deserves in spades. Not only is it backed by nothing, but it is also backed by no one.

I hope that the above point is clear, because it is an important one. One way to think about it is to think about Zimbabwe. If you lived in that blighted country and a year ago you could have had an ounce of gold or a wallet full of that country’s failing currency, which would have been the better bet?

The answer, while obvious, is illustrative…because the wealth preservation role that the ounce of gold would have played for a citizen of Mugabe’s paradise had zero connection with how well gold did, or didn’t do, against the U.S. dollar over the period.

Gold is viewed as tangible money right around the world, and has been for millennia. When the trading herd wakes up to the fact that neither the U.S. dollar nor the euro, nor any other fiat currency, will protect them against the monetary storm that will soon begin tearing the roofs off their cozy offices, they’ll fall all over themselves in the rush for something that will: gold and other tangibles.

Many of you know that the scenario just described is one that we have forecasted for some time. If you think the thing through, precedent to the global monetary crisis, the euro first had to stumble. Well, it now has. The next stage – and given the volatility of the situation, I don’t think we’ll have to wait long for it – will be the realization that there is no safe fiat currency. It is at that point that the massive hurricane, a crisis of confidence in the entire fiat system, will begin ravaging the global economy in earnest.

The price action of gold and, especially, gold-related investments over the last year, have been frustrating…to say the least. But the scenario now unfolding remains step-by-step in sync with our base case. As such, the best way to view this latest correction in the price of gold is as a temporary setback of no real consequence from an investment perspective (unless you use it as a buying opportunity).

The failure of the euro, on the other hand, is not just important…it is as monumental as it was inevitable.


David Galland
for The Daily Reckoning
August 26, 2008

“Wall Street, central bankers, economists, politicians – and most investors too – are betting on a soft landing,” said a friend from New York. “A slowdown in world growth has taken the pressure off commodity prices. Slower growth will help keep inflation down, generally. And as long as inflation is no problem, the Fed doesn’t have to raise rates – which will keep the slowdown from hitting too hard.”

Monday’s International Herald Tribune echoed the good news:

“World economies catch US malaise…pain of slowdown spreads far and wide, threatening businesses and growth.”

The world was growing at about a 5% rate in 2007. It’s expected to slip below 4% next year, with the U.S. economy at less than 1% growth. Since the U.S. population grows by more than 1% per year, this means a lower standard of living for the average person – at least in theory.

Of course, Americans need to accept a lower standard of living anyway. They’ve been living beyond their means for a long time; now they need to live beneath their means to correct the situation. In an economy dominated by consumer spending, this practically guarantees a long period of sluggish growth or recession – no matter what.

But it would be a lot easier to correct the mistakes of the past in a growing economy. Rising incomes would give consumers more room to cut back without too much suffering. Cutting back on falling incomes, on the other hand, is doubly painful.

A correction is unavoidable. The question for us, here at The Daily Reckoning, is: what kind of correction it will be? Will higher prices reduce the value of the dollar – reducing Americans’ incomes, savings and their burden of debt? Or will recession reduce their incomes and the value of their assets?

Whenever we have posed those questions in the past, the answer we have always given was: yes – Americans will get hit both by the jabs of inflation and the haymaker of deflation. So far, that is exactly what has happened. Prices are rising while asset values and incomes are falling. The average consumer is staggered by the blows.

The latest inflation figures show consumer prices rising at 5.6%. And the latest figures for producer prices show them going up at nearly 10%.

What is remarkable is that even with these numbers staring them in the face, investors still buy 10-year Treasury notes yielding less than 4%. Typically, bond investors are the most sophisticated investors. They’re looking at the global growth figures and believe that inflation rates will go down too. Average Americans may expect rising prices for food and fuel. But investors seem to have no worries on that score. You’d think they’d want at least enough yield to protect their capital. But at present rates, an investor in a 10-year Treasury will lose about 1.6% per year. Apparently, he regards that as a small price to pay for protection from falling asset prices.

Oil has already fallen from $147 down to $112. Gold dropped below $800. And with a sluggish world economy, there will be little push from labor rates, he reasons. Bond investors are betting that inflation rates will go back to where they were a couple of years ago – around 2%.

They may be right. But to us, it looks like a bad wager. Where is the margin of safety? What if inflation moderates to an annual rate of 2%? The long bond investor – were he to hold to maturity – would still make only 2.4% on his money. On the other hand, if he is wrong and inflation stays above 4.4%, he earns nothing. If it goes higher, he could be wiped out in a matter of weeks. We’re just guessing here…but the odds that sometime in the next 30 years inflation will rush up above 6%..or 7%…or 10%…are probably greater than the odds that you’ll be able to collect 4.4% for 3 decades and come out a winner.

We’re looking at the big picture…trying to see the large trends before they’re history. We’ve never quite mastered the art of seeing things before they happen, but we’re still squinting, trying to do it…

What we see coming, one way or another, is a fall in living standards. It can happen in one of two ways: either people lose their jobs and their incomes in a deflationary slump, or inflation makes their incomes and savings worth less.

So far, “both” has been the right answer. Our guess is that it will continue to be the right answer.

Yesterday, we saw a big drop in the Dow, more than 200 points. Worldwide, equities have lost about 17%.

More evidence of the slowdown appeared in Atlanta – where unemployment has hit a 16-year high – and in Southern California, where luxury houses in San Diego and Los Angeles haven’t fallen so much in 10 years.

Even more telling, bank lending has jelled to the point that the money supply is no longer increasing at the pace it had been. Until April, it was running at about 20% per year. Then, suddenly, the river dried up. Currently, the money MZM (a measure of the money supply) is only increasing at a 5% rate.

These circumstances have changed the headlines. Inflation is no longer making the news; now deflation is the story every paper tells. Inflation is yesterday’s news. Deflation is today’s.

For tomorrow’s headlines…we’ll have to wait a day…

*** Joe Biden. We don’t follow politics. Money is our beat. But even through our green eyeshades…and across the broad Atlantic…it looks to us as though Obama has made a mistake.

The problem for Obama is that he has gotten his frauds mixed up. His message to the American public was that he was a breath of fresh air…a new man…for a new day…with a new program – “change,” he promises. Of course, it was all humbug; but after so many years of Bushes, Cheneys, Rumsfelds, change seems like a good idea to many voters.

But now that Obama has practically got the keys to the White House in his hands, he thinks he needs to reassure voters that he won’t change things too much. So he’s turned to the old hack, Biden, to signal to the nation that in an Obama administration things will go on as they did before.

The trouble for Obama is that voters are likely to get the message. And they’re likely to think that if it’s change they want they’ll be better off with McCain. The Republican candidate is a hack too, but he has the reputation for being unreliable. We know he’s capable of change. He’s already changed many of his positions in order to pander to the right wing of the Republican party. Once he no longer needs them, he’s likely to change back.

*** Central bankers got together in Jackson Hole, Wyoming over the weekend. As we reported yesterday, the confab was disturbed when an uppity Brit dared to say the obvious – that the Greenspan Fed had erred.

But the champagne flowed and soon salved over the abrasions. When it was over, the bankers were of one mind again. All we know is that the financial world is one “enormous uncertainty,” said one them.

It has been a year since the credit crisis began. By the look of things, it is far from over. JP Morgan, for example, said it was going to take an $800 million loss from its preferred shares in Fannie Mae and Freddie Mac.

More bad news is coming…

*** We took Jules to the train station this morning. He’s beginning his last year at school in Boston.

“What are you going to do next year?” we wondered.

“I don’t know…maybe get into a master’s program. That’s what all my friends are doing. They don’t even ask whether you’re going to do a masters…but where. But I don’t see the point of it. I really have no idea what I’m going to do…”

“Well, I guess you should use this year to try to figure out what you want to do in life.”

“I’d like to…but I don’t even know how you figure these things out. So far, nothing interests me enough for me to want to make a career out of it. But I know I’m going to have to do something. And I’m afraid I’m just going to have to fake it…to pretend to be interested in something…because I’m really not very interested in anything…so I don’t know what to do.”

“Don’t worry about it, Jules,” came the fatherly advice, “what usually happens is that you begin doing something first…then, you become interested in it.”

We put Jules on the same train Henry had taken two days earlier…and waved goodbye.

The stationmaster, a man with black hair and a black mustache, smiled. (It is a very small train station).

“You’re getting rid of them all. Yesterday, your wife was here sending someone off…I guess it was her brother. I guess the children are going back to school. Too bad. It’s always kind of sad at the end of the summer.

“Mothers usually…they come in with their sons and daughters. They get tears in their eyes. Not all of them, of course…some seem pleased to get rid of them.

“But I don’t think your wife was very happy. She probably feels like now she’s all alone at the house…well, with you…ha, ha..

“And the weather is changing too…there was a mist over the fields this morning. That’s what we get in the autumn…well, you know…you’ve been here, what, about 15 years I guess? Yes, the leaves are turning yellow…and we get that mist rising from the river and the fields. This is my favorite time of year; it slows down around here. And the weather is still pretty warm, but the nights are cool…people are wearing sweaters…and look down there…(he pointed down the tracks to the house next door)…you see that? Apples. They’re hanging over the fence. Sometimes I just go down there and pick one, when I’m waiting for a train…that’s what’s nice about the autumn. Apples on the trees…

“Well, it’s always the same…everybody comes down here in the early summer. First, the adults. And then you see them at the station picking up their children, coming back from school or from their jobs…and everybody is happy…then at the end of the summer…I see them at the station again. The kids take off…and then the parents…and grandparents.

“And the mothers cry…”

Until tomorrow,

Bill Bonner
The Daily Reckoning