The Cost of War and the Price of Gold

With the winds of war blowing, John Myers takes a look at likely costs; how the government thinks it’s going to pay for them…and the likely investment implications.

How much would a war in Iraq cost? We ask no one in particular. No one really knows, of course, but there is reason to think the cost could be far higher than politicians would have us believe.

A short and successful war, suggest estimates from two different congressional reports, would cost around $50 billion, compared to about $80 billion (in current dollars) for the Gulf War. But these costs are likely too low, suggests William Nordhaus, an economist at Yale University. Why? One possibility is that leaders are given biased information; another is that costs are understated to gain political consensus. “It is much easier to raise the extra billions of dollars once troops are in the field and bullets are flying,” he notes.

A more prolonged engagement, including an Iraqi urban defense strategy and a refusal by neighboring countries to allow the United States to base forces in their territories, would bump up the cost to about $140 billion, Nordhaus estimates. Neither scenario includes the costs of occupation, peacekeeping and so forth, and both assume no use of weapons of mass destruction and no subsequent terrorist attacks. They also exclude macroeconomic effects, like rising oil prices, for example.

Blowing a country apart isn’t nearly as expensive as trying to put it back together again while also working to keep the peace. The Congressional Budget Office estimates the cost of maintaining “occupation forces” at $17 billion to $45 billion a year. So over the next decade, the United States could be looking at a figure approaching $500 billion for this purpose alone. Add to that anywhere from $25 billion to $100 billion for reconstruction and nation- building.

Undoubtedly, the United States would have to pick up the lion’s share of such costs. And even though Iraqi oil production of 3 million barrels per day would yield about $25 billion per year at current prices, Nordhaus points out that these resources would be spread thin meeting a host of claims ranging from the need to import daily necessities to the cost of satisfying foreign debts.

As for how the oil markets might be affected, a study by George L. Perry of the Brookings Institution outlines possible bad, worse and worst-case scenarios in a supply shock brought about, for instance, by Iraqi destruction of its own supplies or a boycott against the United States. For the record, we doubt that the most pessimistic scenarios would come to pass. However, if they did, Perry predicts a drawdown from our strategic oil reserves with accompanying first-year boosts in crude oil prices to between $32 and $75 per barrel, and increases in gasoline prices to between $1.76 and $2.78 per gallon (these prices would then gradually decline in subsequent years).

A “happy” outcome for the oil markets would be a quick victory, stability in the region and increased Iraqi supplies of about 1 million barrels per day over the five years following the war. But even then, says Nordhaus, “a major increase in Iraqi oil production has a time frame of a half-decade to a decade rather than one or two years.” And crude prices would still be flat to gradually rising over the next decade, using Nordhaus’ model.

This is a sobering analysis indeed. Yet I think that even when the costs of a prolonged military occupation are factored in, Nordhaus’ analysis underestimates the long- term and ancillary costs of war, particularly a “pre- emptive” war.

The renewed emphasis on America as the world’s policeman means an accelerated push for even bigger government. Witness the swift passage of the legislation authorizing the monstrous Department of Homeland Security, a reorganization originally advertised as being “budget neutral.” Rest assured, there will be nothing neutral about it. The bottom line: lots more government spending financed by the federal government’s preferred method of “payment” – inflation…which leads us, of course, to gold.

Prior to this week, one might have be tempted to ask: Has gold outlived its usefulness as a hedge in bad times? John Hathaway, manager of the Tocqueville Gold Fund, concedes that “the worst bear market in 25 years, corporate scandals, accounting heresy, and all too evident geopolitical risks have caused only a modest rise in the gold price.” But, he continues, “this sort of skepticism is reassuring and supports our expectation that significantly higher gold prices lie ahead.”

Hathaway suggests that other possible triggers include an event in the mortgage financing market and interest rate risk concentrated in a small number of banks and intermediaries. Problems in the mortgage finance sector might force policymakers to respond with drastic inflationary measures that could come as a shock to investors hiding in perceived “safe havens” like bonds and derivatives.

“Inflation is still a much more serious problem than deflation,” Nobel Prize-winning economist Milton Friedman said it best in the Wall Street Journal article: “The cure for deflation is very simple. Print money.” It’s clear from Fed rookie Ben Bernanke’s much-cited speech they are in agreement. “Under a paper-money system,” Bernanke said clearly, “a determined government can always generate higher spending and hence positive inflation.” Or in the words of Stephen Cecchetti, formerly employed by the Federal Reserve and now a professor at Ohio State: “Ignore the whining about U.S. deflation.”

Ken Rogoff of the International Money Fund hints at something even broader. He says that if the yen should overshoot on the downside as a result of aggressive easing by the Bank of Japan, then “the need for some kind of international monetary policy cooperation should be uncontroversial.” In other words, let’s all inflate together! Hooray! It’s not obvious from the dollar/yen rate, but against other currencies, such as the euro and British pound, the yen has started to break down.

During an inflationary period, gold tends to do well because the alternative, paper currency, is losing value. [Until this week,] Gold has been marooned at the $320 level, but what stands out in graphs charting the yellow metal’s recent activity is the still-healthy trend upward.

Even a survey of opinions reveals that investment newsletter editors, if cautious, are clearly eyeing the gold market with interest. “A subscriber puzzled over a bearish comment on the dollar,” wrote Jim Grant in a recent issue of his Interest Rate Observer. “He read it and re- read it. Frustrated, he e-mailed that, while we seemed to be down on the greenback, we proposed no helpful course of action. If not dollars, what currency would we have him hold? We confess that our subscriber has us over a barrel. We prefer the euro for vacations in France, the yen for trips to Tokyo and the Swissies for idylls by Lake Geneva without the children. However, as a store of value, we favor none of the above. Our best idea is to hedge one’s dollars with gold or the shares of the companies that own and produce it…”

“I believe gold and gold shares are in the early accumulation phase of a bull market…” agreed Richard Russell, speaking at the New Orleans Investment Conference in November, “[I] tell subscribers, ‘Use this area to accumulate whatever gold and whatever gold shares you want to hold. Take this obvious gold manipulation as a chance to buy gold at what I consider dirt cheap levels.'”

“From this, a true bull market in precious metals might yet develop,” remarked analyst Greg Weldon. While somewhat cautious on precious metals, he is bullish on gold and silver if the dollar weakens again, “amid a general, and broader, depreciation of paper money relative to a base defined by gold and silver.”

Weldon also cites the rising probability of institutional short-covering from bullion banks as a reason to be bullish, along with the fact that “central banks in Europe and maybe even in South America…may remain net sellers of gold. But they are far less willing lenders than they have been in the past.”

“An investment allocation to gold and gold shares makes sense only if one does not expect an imminent return to the investment world of the 1990s,” says John Hathaway. The implication, of course, is that he believes an imminent return to the frothy bubble-era world of the 1990s is unlikely.

John Myers,
for The Daily Reckoning
December 20, 2002

Editor’s note: John Myers, son of the great goldbug C.V. Myers, is the editor of Outstanding Investments. Our man on the scene in Calgary, John has his fingers on the pulse of natural resource profits – including oil, gas, energy and gold.

Here comes Santa Claus…Here comes Santa Claus… Oops…what’s this? No Santa! Stocks went down, not up yesterday.

But over in the gold market, investors rub their eyes.

Santa’s sleigh is headed in their direction, and they can hardly believe it. Gold shot up to $355 an ounce yesterday on the European spot market. Investors had to pinch themselves to make sure they weren’t dreaming. After 20 years of being wrong, the poor gold bugs’ mouths gaped open and their hearts raced…finally!

Meanwhile, in China it was illegal for ordinary people to own gold – until very recently. Now, reports the BBC, people stand in line to buy it – in bars stamped with a sheep. For Daily Reckoning readers unfamiliar with the Chinese calendar, the year of the sheep begins in February.

Demand for gold in China is expected to double in the next year. It seems to be going up elsewhere too – after Fed governor Bernanke announced to the whole world that the Fed was ready to ruin the greenback by printing an almost infinite quantity of them, if need be, in order to prevent falling consumer prices. Currently, 76% of the world’s central bank reserves are in the form of dollars. By contrast, gold is a smaller percentage of reserves than at any time in the last 50 years.

What would you do, dear reader? Imagine that you are in charge of the central bank or Uruguay or Uzbekistan. You read Bernanke’s speech…and you know what a jam the Americans have gotten themselves into – needing $1.5 billion in foreign capital every day just to maintain current spending levels. And you read the headlines from around the world:

“Argentina’s GDP is collapsing at a 10% annual rate…”

“Germany faces more strikes…deflation…aging population…”

“Italian confidence at 6-year low…”

“Oil soars on war fears…”

Ah, yes…there is always war. Military spending is in a major bull market – maybe even a bubble – in America.

In November, the U.S. budget gap widened to $59.1 billion, came the news yesterday. The deficit for the fiscal year – ending next September – is expected to rise to $145 billion. Included in these numbers is the biggest increase in defense spending in 2 decades, giving the U.S. a total military budget of $355 billion. Spending hundreds of billions you don’t have to combat an enemy you can’t find, but who seems to spend almost nothing in comparison, hardly seems like a winning formula. Like all bull markets, this one will probably come to grief, too. But who knows when? Or how?

Central bankers don’t read tomorrow’s papers anymore than we do. But if you were a central banker – or merely an ordinary investor – wouldn’t you be tempted to shift just a little more of your reserves from dollars to gold…just in case?

Here’s our man in New York with the latest news:


Eric Fry, with his mind on Wall Street (sort of)…

– The bear market anti-rally continued yesterday, as the Dow slipped 83 points to 8,365 and the Nasdaq shed half a percent to 1,354. With each new selloff, the “new bull market” that so many investors eagerly embraced in October and November looks more like a plain-vanilla bear market rally – the kind of rally bursts onto the scene like a supernova and flames out just as quickly.

– But the gold rally refuses to flame out. Instead, it casts a bright, steady glow that warms the hearts (and fattens the pocketbooks) of gold bulls and inflation-phobes worldwide. Yesterday, the yellow metal added $4.10 to its recent winnings to finish the New York trading session at $346 (Feb. contracts).

– It looks like Fed governor Ben Bernanke is getting exactly what he hoped for: reflation…or at least the symptoms of it. While inflation may be a delight to investors in the commodity sector, inflation is no delight whatsoever to most investors, and it shouldn’t be a delight to any clear-headed central banker.

– But here in the States, central bankers think it might be fun to have a little inflation. Unfortunately, having a little inflation is a bit like being a little pregnant – both of these phenomena tend to go “full-term.” More below…

– In the meantime…I have to say, with the markets settling down for the holidays…it has been hard for me to get my mind off my stay in Nicaragua.

– The food, for example, was absolutely outstanding. My long-time friend, Hilaire, joined me on the journey. Together, we feasted on fried plantains, chicken and fish prepared in various types of citrus and garlic-based marinades, thick flour tortillas, heuvos rancheros and, of course, rice and beans with every meal. Two young Nicaraguan ladies prepared our breakfast and dinner each day. It was outstanding…

– Hilaire is a dedicated surfer who toted his “longboard” along with him, all the way from Laguna Beach, CA. Laguna, if you’re not familiar with it, does not exactly lack for great surf. But Hilaire gamely decided to give “Nica” a try. After one day spent surfing all afternoon on a perfect “left break,” I asked him if it was worth the trouble.

– “Absolutely,” he replied. “This place is awesome.”

– And having arrived back in Manhattan, I can’t help but recall another one of Rancho Santana’s principal “awesome” traits – its utter isolation. There are no casinos, no McDonald’s and hardly any people. Occasionally, a couple of local fisherman would amble past. But otherwise, no one.

– At one point, we did encounter three globetrotting American surfers who were “rippin’ it up” on one of the nearby point breaks. “How’s the surf?” Hilaire asked them as they were coming out of the water. “It’s pretty ledgy, bro,” one of the surf dudes responded.

– “Oh,” Hilaire said, then turned to me and said under his breath, “Whatever the heck that means.”

– With the markets pretty ledgy themselves, Rancho Santana seems more and more like a good place to ride out the bear market…alas, reckon we must, and reckon we will…Bill?


Back in Paris….

*** When celebrity CEO Gary Wendt took over at Conseco in June 2000, the stock soared from $5 to $20. Gary paid himself $53 million…the company went bankrupt…and now you can buy the shares for pennies. Way to go, Gary!

Economist Paul Krugman looks at stories like this and draws the conclusion he wants. In Krugman’s imagination, high executive salaries illustrate the return of raw, pre- Rooseveltian capitalism…in which the rich get richer at the poor’s expense.

What it really shows is that real capitalists have almost disappeared. They’ve been replaced by small, collectivized shareholders, who participate through pension funds, IRAs, 401ks, mutual funds and so forth. Few and far between are real capitalists – such as Warren Buffett – who actually have a big enough stake in a company to care what the executives are paid. The small shareholders are more like a mob of voters – both clueless and powerless. They cheer on the celebrity CEOs as if they were at a campaign rally with free beer…and hope their man wins for the same reason, so that they will get someone else’s money without working for it.

*** Only recently, sweating over our forthcoming book, have we realized to what extent capitalism has changed. In fact, it is so different from Marx’s description that we wonder if the real thing ever existed. More to come…

*** Eric’s right about Nicaragua, by the way…the journey to Rancho Santana does not end when the plane touches down in Managua, it’s just beginning. The drive from the capital city to Rancho Santana takes about three hours, the final hour of which is spent navigating deep potholes on a badly rutted – albeit quaint – dirt road. But it’s worth the trip.

“Without a doubt,” Eric told me upon his return, “the most beautiful beach in Rancho Santana is the appropriately named ‘Escondido Beach’…[For the non-Latin Daily Reckoneers, escondido means “hidden” in Spanish]. To reach it, the dedicated beach-seeker must hike along a narrow – and sometimes very steep – dirt road that dead-ends on a cliff overlooking the beach, and then down a trail to the beach.

“But once you’ve set foot on the beach itself, you have arrived at a very private corner of paradise. The flawless white beach is framed at both ends by lava-rock outcroppings. It is a truly stunning place.” If you want to see for yourself, take a look:

Rancho Santana

*** If you happened to be wandering through the big Paris department store, Samaritaine, last night, you may have noticed a middle-aged man flanked by two pretty girls, one blonde, 20-years old….the other dark-haired and 16. If you were a man, and didn’t know any better, you might even have envied him. For there he was, in the lingerie department 5 days before Christmas, enjoying the company of two young beauties, his credit card at-the-ready.

Alas, the poor fellow felt as though he were walking along between rumbling volcanoes. Your editor took his two daughters Christmas shopping last night. The two girls are as different as Italy and Indonesia…but alike in that each has her own Vesusius or Krakatoa…ready to erupt. The older daughter goes to college in the U.S. She is quiet, reflective, unsure of herself…modest and easy going. The younger is, well, a fashion model – self assured, poised, quick-witted, and very critical. When the two girls get together after a few months of separation, there is sure to be an explosion. As it turned out, both volcanoes went off last night.

“You think you’re so superior…” said one…

“Well, at least I make an effort…” said the other.

“Couldn’t you both make an effort to get along?” pleaded the poor stock-market watcher, hopelessly out of his element…

More to come…

The Daily Reckoning