ID Monsters, Self-Deceptions & $1,000 Gold

ID Monsters, Self-Deceptions & $1,000 Gold

In the long run, gold has been very effective for preserving purchasing power, and has won out over all efforts by governments to manipulate and suppress it. It is one of the oldest, most tried and proven forms of money,. It often serves as a long-term inflation barometer. However, in the short run, in addition to suffering as a victim of anti-gold campaigns sponsored by governments and central banks, gold may also be a laggard in keeping up with inflation and commodities. It may even do better in certain deflationary environments.

There are obviously some paradoxes involved here, since gold at some point has to play “catch up ball” with commodities and inflation if it is to preserve its purchasing power over the long run. It must also somehow outperform periods of inflation while also outperforming deflation. On top of all of this, gold must somehow remain an eternal form of money.

This series will try to explain these paradoxes and why gold may still be significantly undervalued despite its 68% run from its July 20, 1999 London PM fix low of $252.80 to its most recent high on Jan 13, 2004 at $425.50. I discuss why we may now be in the sweet spot of a continuing gold price appreciation cycle that could possibly last longer than five years and may carry gold well over $1,000 an ounce. This could be augmented by macroeconomic and political fault shifts that may become timely. I also explain political and philosophical reasons for why gold may be significantly undervalued today, and address the risk that the US Government’s confiscation of gold in 1933 may be repeated.

Gold prices are more ideologically and politically driven than virtually all other commodities, if not investment vehicles in general. Gold can serve as a social litmus test regarding respect for property rights and for governmental self-restraint and transparency. Particularly fascinating to me is strong historical evidence that when societies cut their “golden anchor” (go off a gold standard), this frequently coincides with cutting other important social, political, and ethical anchors as well. These societies tend to become more socially “leveraged” as well as more financially leveraged. The abandonment of gold correlates with increasing fraud, centrism, and intrigue, which in the initial phases tends to coincide with increasing marginalization and demonitization of the precious metals. At some point economic imbalances and various forms of social and political fraud reach a crisis tipping point, and then gold and silver tend to make huge moves as they play “catch up.”

I use the term “fraud” in this series in a very loose sense. “Fraud” suggests forms of continuous institutionalized or individualized deception resulting from active measures, sins of omission, or willful blindness in regard to determining and disclosing truth. Often deception and denial are performed on a subconscious level, hence my use of the psychoanalytic “Id” concept. It is not just “neurotic New Yorkers” who are involved here. We are all victims of self-deception to some degree or another.

Although I use the term “fraud” loosely, the reader still needs to be mindful of how even white lies can become destructive. The hard dark side of fraud can be criminal or war-like. The ancient Chinese martial philosopher Sun Tzu once noted that, “All war is based on deception.” A society that experiences growing internal fraud is likely a society that is increasingly at war with itself. It is increasingly filling itself up with all the toxins of rising “hate by other means.” Intuitively we can already begin to grasp how such a society is likely to become increasingly distorted economically and turn its attention away from things of real value. The poisoned tree starts producing stunted limbs and withered fruit.

Intuitively, the reader may also begin to grasp how in an ironic way, societies often get treated in the very long run the way they treat gold.

Gold has a dual nature, both as a commodity and as one of the oldest forms of money.

Gold is the most nonreactive, ductile, and malleable of all metals. It is one of the most reliable electrical conductors for extreme conditions and is also an excellent conductor of thermal energy. A single ounce can be drawn into a wire five miles long, and it can be hammered into a sheet so thin that light can pass through. In addition to jewelry, gold has industrial uses that include dental fillings, “fail safe” auto airbag electrical contacts, and components for cell phones and DVD’s. Gold is used in the manufacture of over 50 million personal computers a year.

An estimated 90% of all gold ever mined still exists in some above ground form. According to Gold Fields Mineral Services, at the end of 2002 this came to 147,800 tonnes (or about 4.75 billion ounces). Perhaps 23% is held by central banks, although the amount of gold they have loaned out since the early 1990’s and can feasibly retrieve is subject to debate. The remaining approximate 77% is privately held for jewelry, bullion, and coin. Average annual demand from 1997 to 2002 was 3,823 tonnes, of which 81% was for jewelry, 9% for retail investors, and 10% for industrial use. Since around 1987, demand has exceeded mine and scrap supply. In 2002 mining supply totaled 2,600 tonnes. The amount of scrap on top of this is difficult to determine but probably not significant. This suggests a supply deficit of roughly one thousand tonnes. (Note regarding measures: 1 tonne = 1 metric ton = 1,000 kg or 32,151 troy oz of gold, 12 troy oz = 1 troy pound)

One might expect that if demand has exceeded supply since 1987, that the price of gold would steadily increase. Up until early 2001, this has not been the case. In fact, adding to the mystery, gold began a decline from $414 in Feb 1996 down to the mid $250-$260 area in mid 1999 and early 2001, threatening to put half the world’s gold mines out of business. As noted by Sprott Asset Management, while officials have acknowledged cumulative gold short position at over 5,000 tonnes, realistically they may exceed 15,000 tonnes, which is roughly five times annual mine supply. A day of reckoning could eventually result in an explosive upside. In Part II of this series I discuss how an artificially strong dollar in the late 1990’s correlated with declining gold prices, and in Part X, I discuss the ongoing law suit by bullion dealer Blanchard & Co. charging conspiracy to artificially lower gold prices against Barrick, a major gold producer, and JP Morgan Chase, a major US bank.

Gold remains one of the most difficult and costly metals to find and extract. Compared to iron, which must be concentrated in geological anomalies five times more than it is randomly found in the earth’s crust to be economically mined, gold must be at least 1,000 times more concentrated than its random natural occurrence. Only about one in five thousand gold mining claims results in a profitable mine. Most rich surface anomalies quickly fade out rather than form economic trends. It takes typically five to seven years from the discovery of an economic anomaly to complete the permitting and feasibility study stages and get a mine into production. Gold costs an average of between $238 an ounce to $300 an ounce (1997 Fed Reserve Board estimate) to extract. The average wedding ring requires extraction and processing of ore in a volume amounting to about six feet by six feet by ten feet.

Despite its rarity, like other commodities, the price of gold responds to supply and demand changes. As an example, over a period of two centuries (16th and 17th), the steady accumulation of gold and silver brought to Europe from the New World by Spain doubled the supply of these precious metals, and dramatically reduced the price of gold and silver in many countries. Supply additions from the California gold rush of the 1840’s and also from South African finds and Klondike in late 1800’s also had an impact. However, since 1492 the annual global gold supply increase has never exceeded 5%, and in the last century it has never exceeded 2% a year.

The demand for gold within a country varies directly with both its degree of industrialization and its per capita wealth. Jewelry demand corresponds not only to wealth but also to cultural and other “mind share” factors. Asians have historically demanded more gold per unit of wealth per person than their Western counterparts. Despite America’s relatively lower “mind share,” the Mineral Information Institute and the Geological Society of America supply information suggesting that the average American consumes in his lifetime more than twice the estimated .75 oz of gold that exists per each of the 6.3 billion inhabitants of earth.

Gold increases dramatically in price as it becomes “monetized,” that is, the more people use it in the place of fiat currencies. Fiat money consists of paper currencies backed only by the taxing power of government. Based upon thousands of years of trial and error, civilizations have found gold to be the most highly desirable form of “commodity money.” Gold is highly portable, divisible, fungible, durable, and has a high ratio of value per unit of weight. These characteristics make gold highly suited to fulfill the three basic functions of money, namely as a medium of exchange, store of value, and unit of account.

Gold can significantly lose value when it is “demonetized” and shoved aside by fiat currencies, but still it tends to retain a certain minimal “mind share” relative to national wealth based on both its jewelry value and fear that some day the fiat currency will become totally debauched.

Significantly, no major countries today are on the gold standard. For the first time in history, they all float on oceans of fiat currencies backed only by confidence in their respective governments that they will not completely debauch their currencies. It is very hard to think of any fiat currency in history that has survived for many generations without becoming totally debauched.

Under a gold standard, owning gold can act almost like owning a share in a country mutual fund that benefits from steady GDP growth. As an example, a person in Britain could buy nearly twice as much with an ounce of gold at the end of the gold standard period in 1914 as in 1821. During this entire period one ounce of gold remained fixed at 4.25 British pounds. Average consumer prices during this period declined by roughly one half as a result of the Industrial Revolution, prosperous overseas trade, access to raw materials, the absence of catastrophic wars, and other factors. Trains reduced the cost of overland transportation by over 90%, and steam and electrical engines dropped the cost of manufactured goods over 50%. During this period, additions to Britain’s gold-based money stock from mining supply grew at a much slower rate than the rate of productivity increases. As explained in Part VI of this series, a number sources such as the Mises Institute video on Money, Banking, and the Federal Reserve claim that business cycles were less severe and economic growth was more consistently strong for both Britain and America while both were on the gold standard than after they abandoned it.

Obviously there are a lot of relativistic variables that continuously impact on the value of gold as both a commodity and as a form of money. The platitude that gold will always be “the eternal constant,” or that in the long run “gold only stores but never gains value” are both too simplistic. Gold is very likely, but not guaranteed, to remain relatively more constant and limited in supply than most other commodities. Under certain conditions, it can steadily gain in value as well as preserve wealth. The value of gold can also decline dramatically due to such factors as demonetization, supply increases, or catastrophic reductions in per capita wealth. It remains highly unlikely in the foreseeable future that nuclear physicists will figure out how to economically move elements on the Periodic Chart into the “AU” square.

When the pros and cons of a gold standard are weighed against those of alternative monetary systems, I believe that gold remains the least bad long-term approach to money, particularly when managed by a least bad form of government.

One often hears that gold does better in deflation than inflation. This is a half-truth. By definition, under the gold standard that existed throughout most of the 1800’s, gold must do well in a price deflationary environment. After all, if prices are dropping, and gold remains pegged to the dollar, and one dollar remains one dollar, logically what else can happen? However, once gold was un-pegged to the dollar and became increasingly demonetized in the 20th century, its price behavior relative to inflation, deflation, and commodities became increasingly erratic. The situation becomes even more complicated given that the terms “inflation” and “deflation” have very different meanings and imply different policies for different economists.

A few paragraphs down I begin my discussion of various forms of “good” and “bad” inflation and deflation. “Goodness” and “badness,” is meant relative to a laissez faire or “bottom up” approach to economics commonly referred to as the “Austrian School.” I agree in principle with the Austrian School that when we search for truth, there should be no philosophical “disconnect” between the “bottom up” fundamentalist principles of microeconomics that apply to small businesses and Generally Accepted Accounting Principles (GAAP) and the national macroeconomic policies practiced by government and central banks. Therefore, the Austrian school provides an invaluable perspective that I return to repeatedly in increasing detail throughout this series.

The late Dr. Roy W. Jastram of UC Berkeley published a now out-of-print landmark study of gold price behavior titled The Golden Constant – The English and American Experience 1560-1976. Franklin Sander, a Tennessee-based gold dealer, posted data from his book on the Internet. In addition, I have supplemented his data with additional data and commentary (provided by the time periods covered by hyperlinks) by market strategist Dan Ascani:

Dr. Jastram felt his data demonstrated a “retrieval phenomenon” where “gold prices do not chase after commodities; commodity prices return to the index value of gold over and over.” He demonstrated that for short time periods, gold, commodities, and inflation do not necessarily move together, although he concluded that gold has maintained its value in terms of real purchasing power in the very long run. His data also shows how gold tended to do well in periods of deflation during the era of the gold standard.

The stagflationary 1970’s provide an important precedent in recent American financial history, particularly since I believe the decade ahead will echo the 1970’s, only worse. After Nixon removed the dollar from the $35 an ounce international exchange rate in 1971, gold began a run up that culminated at a London PM fix of $850 an ounce Jan 21, 1980. This might be interpreted as a variation of Dr. Jastram’s “catch-up” theme. As a prelude, broad money supply growth (M3) had increased to around 10% a year during much of the Johnson administration (Nov 1963-Jan 1969) and the Nixon years (Jan 1969-August 1974). In the mid to late 1960’s the Fed kept a lid on the price of internationally-traded gold during an episode called “The London Gold Pool” in which it sold off U.S. gold reserves as part of a campaign to help keep inflation indicators suppressed while Johnson was simultaneously funding the Great Society programs and the Vietnam War. Eventually the lid blew off of government and Fed intervention. More on this in Part IX, “The Leviathan State: From Consolidation to Excess.”

It is also worth noting that the period from 1951-1979, not to mention most of the other economic periods provided in the chart above, actually consisted of several distinct economic phases that need to be analyzed in detail before one can draw rigorous conclusions. The data is provided here simply to help provide an intuitive overview.

To get a sense of how different phases of the business cycle impact on the price of gold, we must first disentangle the very different and often confusing meanings of the terms inflation and deflation that are bandied about by the government and national media.

The Honorable Humpty Dumpty: “When I use a word, it means just what I choose it to mean –neither more nor less.” Alice responded: “The question is whether you can make words mean so many different things.” The Hon. Humpty Dumpty replied: “The question is, which is to be master – that’s all.”

Bad inflation. This type of inflation typically means an expansion of the money supply and bank credit ahead of gains from productivity and asset growth. More money and credit chasing fewer goods and services typically means higher prices over the long run.

The public often thinks that light to moderate bad inflation is good for the overall economy both in the short term and the long term. It usually thinks that any degree of bad inflation from its inception is automatically good for gold. Both beliefs are demonstrably false in many if not most cases.

Government and central bank spokesmen typically call this good inflation. They claim that credit expansion and government deficit spending “stimulus” helps to generate full employment and full capacity utilization. This in turn supposedly generates additional earnings and economic growth that offset any increased indebtedness and long-term price inflation.

From their “top down” macroeconomic vantage point, this is definitely good inflation to the extent that it allows government and Fed officials to create money and bank credit out of thin air and spend heavily without the aggravation of overtly raising taxes and receiving immediate negative political blowback.

One reason why this is really bad inflation is because it results in an eventual loss in real purchasing power for the average consumer. This is a hidden form of taxation. Creating more money and credit per se does not in itself create any new wealth any more than a counterfeiting ring. The act of simply increasing spending and the process of creating more useful goods and services in a balanced economy are usually two very different things. “Stimulus” spending typically creates the short-term illusion of prosperity at the long-term price of distorting the economy and debauching the currency.

In the short run, the price inflationary impact of new money and credit is usually muted and ignored by most investors. One reason often involves governmental deceit. The article “They Are Lying to Us Again,” archived at www.jimrogers.com describes how government can selectively edit and misrepresent statistics.

Price inflation may also remain initially muted because excess liquidity can first find its way into stock, real estate, or bond asset bubbles. It may experience a prolonged delay in running up commodity and consumer prices.

Lastly, price inflation has been reduced because the dollar has served as a global reserve currency since World War II. Dollars currently comprise around 68% of global reserves. Foreign banks and trade surplus partners have been willing to sop up excess dollars for their own reserve needs or to try to humor the “last remaining global superpower.”

Gold has historically been slow to react to the initial onset of bad inflation. A likely reason is that the first waves of broad money supply and credit growth (M3) tend to give a false impression of economic health. M3 growth may take longer than a year to begin to show up in price increases for consumer goods. In the initial phase of this cycle, banks acquire more deposits, and in turn have more money to lend. Spending increases, corporate earnings may rise, and the stock market may be spurred on by accelerated business activity.

As business activity picks up, the Fed may hike interest rates ostensibly to “cool the economy” while insisting that it has inflation tightly under control. Higher bond yields look even more attractive relative to gold bullion, which pays no interest.

So-called “bond vigilantes” at major investment firms may insist that the free market is raising bond yields at the “whiff of inflation,” and this in itself is adequate to help cut back excessive monetary growth. The public usually buys off on this, and ignores the fact that investment houses have their own axes to grind.

Investment firms typically want to avoid “unnecessarily” scaring their fixed income clients into another asset class such as gold that could help dry up their bond business. Their bond departments are usually major profit centers. Investment firms often use the attractiveness of bonds for conservative investors as a means to open up new accounts and build up their asset base.

Elderly people, who control a major portion of this country’s wealth, tend to perceive gold and other commodities as volatile and risky. It is not uncommon for an elderly person to shop long hours among brokers to get an extra 50 to 75 basis points in bond yields. He may need to be almost hit over the head with very strong gold trend evidence and very bad inflation news before switching over to gold. We may be talking about the kind of person who is becoming increasingly reluctant to drive at night.

In Part X of this series I discuss evidence supplied by the Gold Anti-Trust Action committee that major investment firms have other conflicts of interest. As two examples, they have apparently been in bed with the Fed through the repurchase agreement market that provides backup support for them to manipulate certain markets. They also need to retain access to Long Term Capital Management-type Fed bailouts to deal with the high risks entailed by their very profitable hedge fund clients.

Adam Hamilton charts the short term paradox where a rise in interest rates can hurt gold in the short run in his July 20, 2001 article “Real Rates and Gold.” In the long run, higher interest rates should coincide with rising real inflation, and motivate people to buy more gold as a hedge against inflation. However, in the short run, if people think that interest rate increases are not part of a sustainable rising trend, they may sell off their gold and drive it lower and jump into bonds to try to capture higher yields. Once it becomes more obvious that inflation is very real, is rising, and is no longer containable, then gold starts moving up along with long-term interest rates. But that usually comes very late in the bad inflation cycle.

Fraud Note: Usually government and central bank authorities never admit that spending stimulus and credit expansion is “inflationary,” in fact, quite the opposite, even though M3 growth may already be showing an upward diagonal line on the money supply charts for a number of years. Inflation is always politically unpopular, and politicians typically have to be dragged kicking and screaming to admit to it. In addition, government tends to be a heavy borrower, and does not want to hike its own interest rate burden. Nor it is anxious to index upwards retirement, Social Security, and other transfer payments in the social welfare state. Nor does it want to excite union members and other workers into hiking wage demands. To the contrary, inflation has always been the government’s sneaky way of dropping real wages to bring the labor supply and employer demand curves in alignment and increase employment while pretending to be “doing something” to stimulate the economy and boost wages.

According to “Austrian” economists, the short-term illusion of heightened economic health created by the “stimulus” spending equivalent of a “counterfeiting ring” has other negative ramifications. M3 growth creates false pricing signals that can seriously distort the economy and undermine entrepreneurial calculation and capital formation. “Austrians” argue that artificial stimulus and artificially low interest rates encourage speculative and wasteful economic activity precisely at that time in the classical economic cycle when the write-down of bad debt and more savings and more prudent investment are required. “Stimulus” tends to help sweep underlying problems under the rug where they may fester and grow larger.

But even worse than false pricing signals and governmental deceit, however, is the ability of the Fed and US Treasury to actively engage in active interventions that further distort and compromise the free market. According to the Gold Anti Trust Action Committee (GATA), the Fed has orchestrated central bank dishoarding to artificially suppress gold to create the illusion of low inflation. GATA also believes that through the repurchase agreement market, the Fed has induced its Wall Street allies to use the gearing of futures contracts to suppress the price of gold and silver even further. As previously mentioned, bullion dealer Blanchard & Co. has filed a $2 billion law suit alleging that J.P. Morgan Chase and Barrick colluded in an artificial gold price suppression scheme.

Good inflation: Since I am discussing opposing concepts, I necessarily have to mention “good inflation” to complement the aforementioned discussion of “bad inflation.” The only problem is that I have never seen anyone discuss such as thing as “good inflation” in this context. At the risk of sounding academic, “good inflation” could mean adding new assets to the system (asset “inflation” in the sense of asset accretion or asset accumulation) while keeping the money supply roughly the same, such as doubling the land mass of the U.S. for nominal cost under the Louisiana Purchase or adding more manufactured goods without raising prices due to enhanced production methods. These accretions tend to drive down average prices while adding tangible wealth and would tend to have the same positive impact as good deflation mentioned later.

Bad Deflation: This is the kind of environment where gold often outshines all other asset classes, and merits extended discussion. This is the overall underlying environment I believe we have been in since the Nasdaq top in March 2000, and it could last for many more years. But first some background on the bizarre situation that currently exists with both the gold market and the stock market.

Bad deflation is typically the back-side of the aforementioned bad inflation cycle, where over-inflated asset prices created by excessive “stimulus” start coming down. As discussed in my paper “Amidst Bullish Hoopla: A Behind the Curtain Look at Fed Desperation and Intervention Wizardry,” where I describe stock market overvaluation in more detail, the Fed has been fearful that if the stock market bubble starts deflating too quickly, this could lead to a negative wealth effect, reduce consumer confidence and spending, undermine bank collateral, dramatically increase bankruptcies and unemployment, and risk a depression. However, by dropping the Federal Funds rate down to 1% and by gunning the money pump by about 10% a year over the past few years to stave off asset bubble deflation, the Fed has risked creating more bubbles elsewhere, such as in the real estate and bond markets. This money supply growth has been showing up in rising consumer prices. This is the type of inflation that the Fed and US Government try to ignore. Hence, we are now simultaneously experiencing consumer price inflation while witnessing overvalued stock, bond, and real estate markets that threaten serious deflation.

As a response to the Fed’s alleged anti-deflation activities (and related factors), the S&P 500 has risen about 43% since March 2003. Conversely, as a response to fears about long-term inflation (and related factors), the un-hedged gold stock index (HUI) has climbed over 500% in the last three years in a “stealth bull market” that most Wall Street firms have downplayed.

Historically the gold market and the stock market have been negatively correlated. Rising long-term inflation is usually very good for gold, and very bad for the stock market. The bullish activity of both markets may be signaling two completely different outlooks for the US economy.

Negative real interest rates are usually a crucial factor in a bad deflation cycle to account for the out-performance of gold. Negative real interest rates mean that the rate of real inflationary erosion in purchasing power from the long-term impact of the underlying growth of M3 is greater than the nominal interest rates one can get from CDs at the bank. Although Americans have been in a negative real interest rate environment since at least the mid- 1990’s, it has become particularly dramatic since the Fed reduced the Federal Funds rate down to 1% by summer 2003 while maintaining broad money base (M3) growth in the 8-10% a year range.

An important cause of negative interest rates is central bank intervention. Let us compare how interest rates set by the Fed may differ from those that might be created by a free market. The Fed has dropped its Federal Funds rate to a 45 year low of one percent to ostensibly stimulate the economy to avoid a collapse of puffed-up asset prices. The Thirty Year Treasury bond hovered around 4.9% as of mid Jan 2004. In my Amidst Bullish Hoopla article, I discuss how hedge funds can work with the Fed and allied Wall Street firms to transmit lowered interest rates out the yield curve with the bond carry trade. Also, the Fed can use Open Market Operations to buy bonds to prop up bond prices and drive interest rates down, often by making purchases with money created out of thin air that ultimately create a hidden tax on the average American.

Contrast all of this with M3 growth, a truer indicator of real long-term inflation. This has been growing between 7%-10% a year since 1995. Let’s say 8% on average. If the free market were to price a bond, it would probably take into account this truer long term inflation rate, and add on top of that a risk premium of let’s say a historical average of around 2.50% . That gives us 10.5% as a rational hurdle rate for setting a free market floor on expected interest rates. Now, let’s deduct the aforementioned Thirty Year Teasury rate of 4.9%, and we get a possible real negative interest rate of 5.6%. For individuals in money market funds that pay less than 1%, the negative spread could be over 9.5%.

Gold, which pays no interest but has the potential to appreciate, starts to look very attractive compared to the negative real rates of return on bonds, CDs, and money market funds. Better yet for gold, if interest rates eventually go up, the resale value of bonds will come down, giving bond investors double black eyes. They will lose both from their low rate of current interest income combined with capital losses on the reduced resale value of their bond holdings. (When interest rates go up, bond resale values go down). Conversely, to the extent that rising long term interest rates signal rising long term inflation, this becomes another plus for gold. Last, but not least, once investors sense that stocks have peaked and may be set for a price decline (deflation), gold and other “commodities” begin to look relatively more attractive. We live in era of central bank and government intervention whose continuous stimulus efforts to arrest asset price deflation are likely to add inflation to the pro-gold story.

There is evidence that markets may tend to be inefficient in adjusting to an environment of continually rising interest rates. British economist Prof. Tim G. Congdon noted in his WGC research study no. 28: “As the double-digit annual inflation rates of the 1970s came as a shock to savers, it took them time to catch up with the new investment paradigm. Interest rates lagged behind inflation and real interest rates became negative, creating the ideal conditions for rising prices of gold and other so-called "hard assets" (oil, real estate, commodities).”

Fraud note: From the Austrian viewpoint, bad inflation cannot go on forever, even as a way to stave off bad deflation. Bad inflation stimulates speculative mal-investment, excessive debt, and asset bubbles that distort the economic system while debauching the currency. The economy may become so distorted that new waves of money only generate stagnation and inflation (“stagflation”), analogous to a drug addict whose fixes start breaking down the body. Since summer 2003 the M3 growth and money velocity charts have been tapering off, partly because the system is getting so saturated with cheap credit that the Fed is beginning to push on a string. Also, a debauched currency may trigger a currency crisis (a rapid exchange rate slide) that can cause foreign imports (10% of US GDP) to become more expensive and contribute towards prolonged malaise.

Austrians believe that often the best thing to do is simply leave the economy alone and allow the free market to sort things out. Go ahead and let asset bubbles deflate on their own. After a period of brief but intense pain from bankruptcies and collapsing prices, entrepreneurs and other bargain hunters typically step in, reshuffle assets into more productive enterprises, and economic growth will start again. That actually happened in America during the Martin Van Buren administration (1836-1840) that experienced a sharp stock market correction and a money supply contraction of 30%, somewhat similar to the first two years of the Great Depression beginning in 1929. The US Government actually reduced its spending during this period, and the economy turned around at the end of the painful two years. (c.f. Dr. Jeffrey Hummel, “Martin Van Buren: What Greatness Really Means”). In contrast, the Great Depression dragged on from 1929 to the 1940’s despite the Hoover administration interventions and FDR’s New Deal. Dr. Murray Rothbard claims in America’s Great Depression that government intervention actually served to prolong and deepen the Depression, and in fact created a second depression within the Depression.

I consider the aforementioned two paragraphs a “fraud note” under the theory that many senior government and banking officials in America are aware of all of this, but are afraid to educate the public for fear that this could lead to the curtailment of pork spending and central banking special privileges that I describe in Parts VIII and IX about the history of gold in America.

Good Deflation: This involves price level declines from improved efficiencies and from asset accretions. The money supply is held relatively constant. Earlier I discussed how the Industrial Revolution helped drive down prices while Britain was on the gold standard. It helped double the purchasing power of the British Pound over a one hundred year period. When currency is pegged to gold, price deflation must by definition be good for gold. Today we see another dramatic example of good deflation in the computer chip industry in which computing power has steadily declined in price in accordance with “Moore’s Law.”

America is also experiencing a form of price “deflation” from low cost imports from Asia, which actually retard the rise in American consumer prices. I hesitate to label this “good” deflation because of many complicating issues. The theory of international free trade is supposed to enhance the wealth and prosperity for all parties involved, and not result in the lopsided situation we see in America today with a serious loss in its jobs and its manufacturing base and a dangerous rise in debt. (A worthy discussion of these issues would require another paper).

Most countries today inflate their money supply at much faster rates than productivity gains. This submerges the gradual accretive effects of good deflation on the price action of gold. The big moves in gold prices usually pertain to other factors such as the deflationary side of business cycles, central bank interventions, fears of runaway inflation, and changes in currency exchange rates.

In August 2003, Newmont Mining President Pierre Lassonde commented: “Eighty percent of the variability of the gold price is due to the U.S. currency valuation. So where the dollar is going is the key determinant of the U.S. dollar gold price. And when you look at the structural imbalances in the U.S. today, they are no different than they were 12 months ago -- in fact they are worse,"

A decline in the dollar can help create a rising floor underneath the price of gold due to an arbitrage principle often referred to as the “Law of One Price.” This can apply to other high unit value, highly transportable goods in addition to gold.

Here is an example of how it might work: Suppose that $1 US dollar equals 1 unit of Foreign Currency (FC). Imagine that ounce of gold sells for US $400. An ounce also sells for FC 400 units. Now suppose as a result of a dollar slide, US $2 now equals FC 1 unit, but the gold price has not changed in the US or in the foreign country. I can now buy an ounce of gold for US $400 in the US, sell that gold at an FC bank for FC 400 units, and then swap the FC 400 units for US $800. By repeating this all day long, I would put upward pressure on the price of gold in US dollars, downward pressure on gold in foreign units, and upward pressure on the value of the $US, causing a decline in the $/FC unit conversion rate.

The formula for the arbitrage is: $/ounce of gold = $/FC unit * FC unit/ounce of gold.

If we keep FC/ounce of gold constant, and increase the $/FC ratio because of a slide in the value of the dollar relative to FC units, then $/ounce of gold in the U.S. is likely to go up.

According to gold analyst Paul Van Eeden, currency exchanges changes are more likely to drag gold along than gold prices changes are likely to impact on currency conversion rates. This is because the gold market is relatively small compared to the gargantuan size of currency markets.

While currency exchange movements may have a high correlation with short to intermediate term gold price swings, they do not explain how the price of gold gets calibrated in the first place before the currency change effects kick in. My history of gold in America in Parts VII to IX should give the reader a better sense of how the baseline value of gold can dramatically decline as the banking system reduces its gold reserve requirements and engages in other “demonitization” processes. In addition, currency traders arbitrage against a wide basket of goods, and not just gold alone. Finally, it may be hard to distinguish between how movements in gold prices and currency exchange rates may relate to psychological expectancy effects among traders (also known as a “self-fulfilling prophecy”) as opposed to mathematical relationships based on hard fundamentals.

Analyst Clive Maund has noted that gold has tended to go sideways or slightly down in foreign currencies such as the Euro, South African Rand, and in Australian and New Zealand dollars as they have appreciated while the dollar index has declined dramatically over the last two years. They have indicated a weak but not insignificant “Law of One Price” relationship.

Many gold gurus have noted that the rise in the price of gold denominated in US dollars in the last two years has actually reflected a dollar bear market rather than a real gold bull market. Rick Rule, President of Global Resource Investments Ltd, observes that gold is the only form of money that does not have an inflationary constituency. Currently all of the major industrialized nations of the world, including Switzerland, are debauching their currencies to maintain export competitiveness relative to the U.S. The next major phase of a true gold bull market will probably take place when gold starts moving up against all the major currencies of the world as countries continue the game of “beggar thy neighbor.”.

To better understand currency exchange movements, it is helpful to disentangle their short term, intermediate term, and long term causes. There are many different causes behind a slide in the US dollar than may not be directly related gold, but nevertheless may get transmitted into a rising gold price through the so-called “Law of One Price” arbitrage.

In the short run, currency exchange rates tend to be heavily influenced by investment capital flows. Back in 2000 America received capital inflows in the area of around two to three billion dollars a day from foreigners. One important factor was a desire to participate in the 1995-2000 stock market mania. Anther important factor was a belief by foreign investors that the dollar would continue to remain strong relative to other currencies, and not fall and hurt the value of their non-repatriated US investments. Lastly, many countries have been willing to continue investing their trade surplus dollars in US securities to stay in the good graces of the world’s “last remaining superpower.”

The US stock and bond markets remain a risky bet that foreigners will continually hold rather than eventually bolt for the door. The S&P index is trading at a P/E multiple that is more than twice its historic average. Its reported or “pro forma” earnings are often twice “real” (or GAAP or core) earnings, as noted in my article “Bear Case Overview.” Also, bond interest rates, at 45 year lows, seem to have nowhere to go but up. A Forbes magazine charticle “Here We Go Again” suggests that the US market could still be mimicking the early phases of the Japanese market of the 1990’s. If the secular bear market that may have begun in March 2000 returns, it could scare foreigners into selling off their US securities and put further downward pressure on the dollar.

In the intermediate term, exchange rates tend to fall in line with the Purchase Power Parity concept. The Economist Magazine’s Big Mac Index uses the Big Mac hamburger, representative of a basic consumer item sold in over 118 countries as a rough yardstick to help calibrate relative currency under-valuations or overvaluations. In 2002 it signaled that the dollar was very overvalued. Li Lian Ong, Senior Analyst at Macquarie Bank, has authored The Big Mac Index. According to the Amazon.com review of her book, the index “…Could have been used to predict the Asian Currency Crisis and the Mexican Peson stand-off where more traditional economic measures failed.”

In the long run relative currency valuations relate to different rates of productivity gains and different levels of monetary discipline of different countries. They bear a rough analogy to relative values of shares of stocks in companies, in which inflation is similar to stock dilution and rising debt is bad (to include trade deficits) if it increases at a faster rate than sustainable earnings growth (analogous to GDP growth). Professor Tim Congdon, Director and Chief Economist of the economics consultancy Lombard Street Research in London, published World Gold Council Research Study 28 in 2002 which he modeled such factors as debt to GDP ratios, interest rates, and growth rates for the US. He cites three reports predicting the strong possibility of a serious currency slide (more on this later), and asked whether the US could make the Herculean shift of 5% of GDP to exports fast enough to halt deteriorating balance of trade and indebtedness trends.

The fundamental outlook for the US remains negative in this area. The declining dollar is likely to have only a marginal impact in correcting America’s balance of trade problems. America has lost about half its manufacturing jobs in the last thirty years and is addicted to foreign goods, plus certain foreign producers such as China and Japan loosely devalue or peg in line with the dollar decline to maintain their export competitiveness. There is no credible evidence that the Federal Government can rein in runaway spending on any level, be it military or social, and is arguably already bankrupt (discussed in more detail in Part V). Fed Governor Ben Bernanke has announced that the Fed is prepared to inflate without limit to smooth over problems. Asian demand is putting steady upward pressure on commodity prices, which will likely squeeze American incomes. China is becoming increasingly capable of fueling its growth in Asia independently of the US, and Chinese investors may become less inclined to support America’s trade deficits and use their capital instead to fund internal growth. Other foreigners will likely cut back on their US investment for fear of suffering further losses from continued US dollar declines.

Eventually, to fund America’s growing deficits, the Fed will have to accelerate money creation to monetize part of America’s debt and also hike interest rates to try to lure foreign investment back. Rising interest rates will likely slow the economy and hurt the stock, bond, and real estate markets. The magnitude of America’s trade deficits and indebtedness suggest that the US will eventually wind up with double-digit interest rates and hyperinflation.

I have already discussed in my “bad deflation” section how gold tends to be a late bloomer in the bad inflation cycle, often trailing commodities, and how it tends to benefit in a negative interest rate environment. James Turk’s commodity chart shows us the explosive “generational” bull market in commodities that took place in the stagflationary 1970’s. This followed the sideways commodities markets of the 1950’s and 1960’s. This raises an interesting question regarding how explosively commodities might move in the decade ahead if they become the focus of another generational event proportional to the commodities bear market that lasted from 1980 to 2000.

Like gold, commodities in general can have a dual nature as investment vehicles once investors perceive them as a store of value in an inflationary environment. The 1970’s era even showed how commodities could become the focus of an investment mania.

Interestingly, commodities cycles have been getting longer in the last eighty years, as suggested below by the Commodities Cycles chart provided at: www.ditomassogroup.com. This may be an indicator that we could be entering the early phases of a long term commodities bull market.

We might also note the “generational” 30 year Treasury Note chart below. Please recall that the Fed began to hike interest rates between 1998 and 2000 to help keep a lid on inflation and take some of the speculative air out of the stock market mania. Jim Roger’s article “For Whom the Closing Bell Tolls” criticizes Fed Chairman Alan Greenspan for not hiking margin rates and reducing monetary stimulus much sooner. My guess is that somewhere around or prior to 1998 was probably the real bottom of the generational trend in declining interest rates. The artificially low interest rate environment we have been in since 2000 could simply reflect a postponement of fundamental inflationary realities.

The chart below provided by Michael Landis in his article “The Once and Future Money” that overlays the price action of gold and the exponential rise in M3 and government spending provides another perspective on the rising waters that may be filling a cracking dam to the brim. Eventually, long-term interest rates, gold, and commodities may make a dramatic upward move together as they did in the late 1970’s.

James Sinclair said in a July 20, 2002 interview with James Puplava that he exited gold in 1980 near its top at $850 following its long run in the stagflationary 1970’s. He took his cue when Fed Chairman Paul Volcker hiked short term interest rates to 16%. To Sinclair, this showed that the Fed was finally serious about stopping inflation. This was after the prime rate had held over 20% for over a year. This dramatic Fed tightening created a credible positive real interest rate environment and an air of certainty about interest rate trends (stable to down). All of this was bad for gold, and suggested a top.

Today, even though the M3 growth charts look scary, the government, central bank, national media, and public at large are still in denial. Let us call this stage the Phase I denial stage. We still have at least two more phases to go. Phase Two entails general acceptance of a serious inflation problem. Phase Three entails taking decisive steps to stop the problem, as Fed Chairman Volcker did in the early 1980’s. Using the Sinclair method, one might simply buy gold and silver stocks now and hold until America shows credible evidence of achieving Phase III. This will probably be many years from now.

In his article “To the Moon, Alice!” James Puplava wrote about how in the first phase of a long term bull market, the smart money gets in. Then in the second phase the institutional investors get in. Finally, in the third and last phase, the little guy gets in. Puplava thinks we are in the tail end of phase I.

Mass media publications are often a contrarian indicator for when the little guy is finally catching on. If Puplava is correct, one might still consider accumulating gold and other precious metals stocks now and then wait until someone like Pierre Lassonde, President of Newmont Mining, makes the cover of Time magazine before inserting stop loss orders.

BACK OF THE ENVELOPE ANALYSIS
FOR $1,000 GOLD IN FIVE YEARS

To justify my $1,000 low-end price target within five years, I need to “run the numbers” and then explain the assumptions behind them. Here they are:

I intend each of the above factors to be understated. Upon reviewing my assumptions, the reader will be able to see how gold could possibly rocket up to over $2,000 or $3,000 an ounce much sooner than five years. But before anyone gets too excited, let us examine each assumption in some detail.

As usual in the investment business, I have a duty up front to warn readers that market projections are inherently risky. There is always some chance that we could get blind sided by unforeseen factors and that gold could behave contrary to expectations. Conversely, it is also possible that the rise in gold could vastly exceed expectations.

Please be aware that what applies for gold in this article also applies to silver, which closed at a $7.53 an ounce on March 19th and has enjoyed a greater bull market in the last year than gold. I zero in on gold because it is the primary form of “natural money” that has been the main target of manipulative efforts. Silver, historically the second most natural form of money, has been a secondary target in support of campaigns against the main target gold.

At the March 16, 2004 intra-day market price of $400 an ounce, gold recovered back to its 1996 level. It dipped to a low of $252.90 in June 1999. Can we assume that gold was at a reasonable market level in 1996, was artificially suppressed in the following years, and that now we can expect it to catch up to the inflation-adjusted level where it might have been without the suppression?

Gold prices in current dollars. [Source: Gold Newsletter, Feb 2004]

Inflation-adjusted approach from a technical or historical support base: At $400 an ounce in 1996, gold was fifteen years into a commodities bear market and had showed sideways technical trending evidence of “basing out.” The inflation-adjusted gold price chart above supplied by the Gold Newsletter suggests that gold formed a base between 1993 and 1995 at roughly $500 an ounce in today’s dollars.

In a 2001 article that looked at multiple valuation perspectives, James Turk used CPI increases from gold’s $35 price in 1934 to determine that gold should be worth $463.

In his April 2003 article “The Gold Price,” Paul Van Eeden extrapolated the price of gold adjusted for broad money supply M3 growth and gold supply inflation since 1947 and came up with a value of $700 an ounce.

Supply and demand analysis: Frank Veneroso, a consultant to central bankers, published the Gold Book in 1998, in which he estimated the equilibrium price of gold at $600 an ounce for 1996. In his analysis, he looked at supply and demand inelasticity and the likely market impact if central banks desisted from selling off gold to fill the 1,000 tonne supply deficit in 1996. The gold market has experienced significant supply deficits since 1987. The decline in gold to $252.90 in June 1999 was a major historic anomaly, given that countries tend to jealously guard their gold hoards as strategic assets, and also given that gold supply gaps usually foster higher prices until deficits are eliminated.

Gold vs. stock market valuation: Another equilibrium approach compares gold to trough valuations of the Dow. According to Reginald Howe in his Nov 1999 Golden Sextant commentary, "The Dow/gold ratio moved from 1.01 in 1897 to 18.4 in 1929 before the crash, then fell to 2.01 at the bottom in 1932 (gold fixed at $20.67/oz.). From 28.26 at the Dow peak in 1966 (gold fixed at $35/oz.), the ratio fell to about 3 at the bottom in 1974, and to 1.04 in January 1980 at the modern peak in gold. At the Dow’s peak in August 1999, the ratio was over 40, an all-time high.”

If we pick a ratio such as 3 from 1974, and assume a worse case scenario 72% fall in the Dow to 3,000 within five years from rising interest rates, this could imply $1,000 gold. This would fit older patterns if gold continues to play “catch up” during a continued asset price deflation credit bust cycle combined with simultaneous consumer price inflation.

The chart above, incidentally, is very useful for another purpose. It provides a graphic indication of the huge and ever growing boom-bust pulse surges of credit under the fiat money and fractional reserve banking system seen in America since the creation of the Federal Reserve Banking System in 1913. The Tobin Q Ratio that coincides with the Dow/Gold ratio above helps to validate this concept, since it divides the market capitalization of all companies by their replacement value. I will return to the topic of horrendous liquidity surges in a fiat money system in Part VI “The Propaganda War Against Gold.”

Getting back to the inflation-adjusted Feb 2004 Gold Newsletter chart provided at the beginning of this section, if the growing pulse surge pattern repeats itself, and gold tops its last high in 1980, then we will likely see gold over $2,000.

650 Year Historic Gold Price [Source: Sharelynx historical charts archive]

In the very long-term historical chart above, we see a tug of war between several factors. On the one hand, we see the price of gold drop due to a major supply shock involving gold introduced to Europe from the New World after 1492. Lesser price declines followed discoveries in California and South Africa. An even bigger erosive force has come about when governments have demonetized gold by effectively discarding various elements of a fully negotiable gold standard while inflating in times of war, such as during the Napoleonic Wars (War of 1812 for the US), World War I, and World War II. Conversely, gold gained in value during the period of the international gold standard of the 1800’s combined with the gains in wealth created by the Industrial Revolution, when the world added wealth at a greater rate than miners could add gold supply. The source that created this chart claims the price of gold peaked several times at $627 an ounce during this period in 1998 constant dollars. The gold price in constant dollars also increased during periods of deflationary bust (the 1930’s) and speculative demand (late 1970’s).

In Part II of this series I described how the purchase power parity concept applies to international trade. Here we try to put gold through a time machine. According to economist Mark Skousan, a tailored suit cost the equivalent of an ounce of gold or $20.67 in 1933. According to Peter Brimelow in “Gold miners and Haberdashers” a tailored suit cost $1,260 in 1997 dollars. John Hathaway of Tocqueville Funds commented in Nov 2003: “According to Alan Flusser, renowned author and designer of exclusive menswear, a bespoke gentleman’s Saville Row suit could be purchased in the early 1980’s for around $800. Today, the number is over $3000.”

We must deal with a number of complex issues in trying to adapt the purchase power parity concept through time. America had stable money under a gold-plated standard until the Federal Reserve was created in 1913. From then gold became continually marginalized and “demonetized” in various ways as the money supply grew rapidly. By the 1920’s the official price of $20.67 an ounce had already become a kind of governmental and central bank “bluff” that did not reflect underlying money supply growth realities. Because the U.S. had gobbled up huge gold reserves from various World War I combatants while a “neutral” trading partner, in a bizarre way it was able to aggressively inflate the money supply and look strong in gold at the same time. In 1933 FDR confiscated gold from private ownership and then arbitrarily hiked the official gold price to $35.00. In 1971 Richard Nixon removed the dollar from gold completely. In 1974 private gold ownership rights were restored, but otherwise to this day gold has no fixed exchange relationship with the dollar, whose supply has been accelerating at historic rates. The price of gold per ounce as a purchase power parity yardstick in each of these periods has a very different meaning based on many social, political, economic, and monetary factors, to include ways that central banks can play with the price of gold through systematic selling and governments can reduce its negotiability through various forms of demonetization.

In addition, the purchase power parity approach does not necessarily factor in how the advent of new technology should make items cheaper. As mentioned in Part I of this series, an ounce of gold purchased twice as much in Britain in 1914 at the end of its prolonged gold standard era compared to ninety years earlier. Much of this gain related to production cost reductions from the Industrial Revolution. Perhaps an ounce of gold should buy at least two or three low end men’s suits today compared to one a hundred years ago, whereas it may only continue to buy one low end luxury suit on the high end. As an example, today one can buy a low end Men’s Warehouse Suit for $400. Do we double or triple this number to $800 or $1,200 an ounce for comparison purposes if it reflects a substantial input of modern low cost manufacturing methods or modern low cost logistical access to low cost Third World labor? But then again, in the chart above, if gold reached $627 several times during the gold standard era, and the real wealth of the world has grown much faster than the average 2% annual supply addition to the world gold supply during the 20th century, then why would not gold's true international value be some multiple of $627?

The topic of gold suppression is worth covering in some depth. This is because the degree of the effort and the extreme circumstances required to keep gold down helps to validate its baseline value in a negative way, much like the way a physicist who measures the force required to compress a spring helps us understand the power of its potential spring-back. We also need to address how gold and the dollar may have both been manipulated simultaneously, since the dollar and gold tend to move inversely to each other. (cf. my discussion of the so-called “Law of One Price” in Part II of this series). We also need to get a sense regarding how these same forces for gold suppression may now be running out of ammunition and may be in retreat, possibly allowing free market forces to push gold towards a much higher free market equilibrium level.

I believe that gold price suppression between 1996 and 2001 involved both “lucky” short- term events for the U.S. dollar combined with very real manipulative efforts to support an upward dollar trend and a downward gold trend. Today what were considered “virtuous circles” during that period have now turned into unwinding “vicious circles.”

Paul van Eeden’s April 2003 article “The Gold Price” describes how the dollar increased 120% from 1990 to 2000. One factor involved foreign capital pursuing America’s 1995-2000 stock market mania. Van Eeden claims that flight capital was an important factor as various countries experienced currency crises. As examples, from 1994-95 the Mexican peso declined 50%, from 1995-96 the Japanese yen lost 24%; from 1996-98 during the Asian crisis the Indonesian rupiah lost 76%, the South Korean won lost 56%, the Malaysian ringit lost 40%, and the Philippine peso was down 40%. In 1998 the Russian Ruble was down 70% and the “new” Brazilian real collapsed. And on it went. In “Understanding the Gold Price” written in 2000, Van Eden claims that the Asian crisis caused various countries to sell gold to help defend their currencies, helping to knock the gold price down from 1997-1998.

Jim Roger’s article “For Whom the Closing Bell Tolls” explains how loose margin, credit, and monetary expansion policies by the Fed helped fuel the stock market mania, which in turn attracted foreign investment and supported the strong dollar. Loose lending practices by big money center banks helped create major mal-investments in Asia and elsewhere that set up many countries for crises. Hedge funds fueled by loose speculative capital then helped trigger currency crises for their own gain.

The Clinton administration wanted the world to view America as a safe haven, and had very powerful tools in its arsenal to help “spin doctor” this story. I discuss in my “Amidst Bullish Hoopla” article how the U.S. Government created the Exchange Stabilization Fund in 1934 to help “stabilize” currency exchange rates. Of course where “stabilization” turns into “manipulation” few people seem to notice or care. The U.S. Government created the “moral climate” to manipulate currency in conjunction with other markets, to include the stock and precious metals markets, with the creation of the Working Group on Financial Markets following the 1987 stock market crash.

Many different factors played an important role in the “lucky” 1990’s. The US dollar comprised about 68% of global bank reserves. The U.S. remained the world’s last “Global Superpower” after the collapse of the Soviet Union. The US comprised about 25% of global GDP and presented an enticing market for foreign exporters. Last, but not least, the US has maintained a hegemonic relationship with two of its major trading partners, Germany and Japan, since World War II.

The dollar and gold can have an inverse correlation with each other whether or not there is government or central bank intervention. Manipulation can muscle gold down a quantum level while it continues to zig and zag in short term trading movements relative to dollar futures. Put another way, a long term inverse correlation between the dollar and gold does not necessarily disprove the manipulation case.

James Puplava described strong evidence of dollar interventionism in the first hour of his May 31, 2003 Financial Sense Newshour show “Pulling a Robert Rubin.” Before becoming Secretary of the Treasury during the Clinton Administration, Robert Rubin had been a currency trader at Goldman Sachs and understood the psychology of the markets. Normally central bank interventions would buy enough dollars to arrest a dollar decline and then stop. Beginning in 1994 under Rubin, the buying continued to drive the dollar upwards and burned leveraged hedge funds. Puplava noted, “There was a clear message here, and this was the beginning of the strong dollar policy. They would sell gold and support the dollar, and that became the central focus…This has been documented at GATA’s web site.” On his show, Puplava frequently talks about “flag pole” rallies in which aggressive buying in futures pits involving index contracts are used to move markets at strategic moments.

Fraud note: It would not be out of character for American political leaders to manipulate markets or suppress important economic information to achieve short-term political goals. As an example, Pat Buchanan described hubris, gross irresponsibility, and a high level game of hot potato in his article “Bailing Out Brazil –Or Robert Rubin?." Because the Clinton Administration had heavily promoted the North American Free Trade Agreement (NAFTA), it had a strong political motivation to help bail out arch trading partner Mexico during the 1994 peso crisis. Major US money center banks with serious Third World debt exposure liked the way the strong dollar helped problem borrowers by encouraging US demand for their exports.

The Bush administration has swept growing Third World debt problems under the rug that it inherited from the Clinton administration because, as Buchanan puts it, “No one wants to be in the pilot house when the ship hits the reef.” Incidentally, another monstrous debt problem that the Bush Administration is denying is the $44 trillion Medicare and Social Security liabilities “abyss” identified by Dr. Laurence Kotlikoff in his “Going Critical,” article and also on the Financial Sense Newshour.

There are all kinds of political agendas we might come up with ranging from pork barrel re-election strategies to longstanding Neo-Con interventionist plans that could help explain who might benefit from gold suppression and an artificially prolonged “feel good” economic environment. More on motives later in this series.

There are currently three major areas that show ample evidence of gold suppression: The first is the Blanchard suit against Barrick and JP Morgan Chase. The second involves data related to aggressive central bank selling of gold hoards. The third involves commodities market manipulation. Let us briefly review each of these areas:

Blanchard & Company, the largest bullion dealer in America, filed a $2 billion suit in Dec 2002 against the major money center bank JP Morgan Chase and the senior gold mining company Barrick Gold alleging substantial client losses as a result of unlawful price manipulation, anti-trust violations and unfair trade practices.

The Blanchard case has now moved to the discovery phase. This is very significant for several reasons. First, it may make public hard facts regarding unlawful collusion to drive down gold prices. Secondly, Blanchard filed an injunction to force Barrick to cover its massive short position. If it wins its case, efforts by Barrick to cover its short positions could substantially move the price of gold. Lastly, the discovery process may shed light on the gold-derivatives related positions of JP Morgan Chase. Already JP Morgan Chase, one of America’s largest banks, is believed by many experts to be leveraged at over six times its capital and to have the world’s largest gold derivatives exposure. Many investors are worried that a sudden run up in gold prices could detonate a meltdown similar to the Long Term Capital Management (LTCM) fiasco in 1998.

Jay Taylor, who publishes J. Taylor’s Gold and Technology Stocks, interviewed Blanchard & Co. CEO Donald W. Doyle for his 15 Dec 2003 issue. According to Doyle, JP Morgan Chase acquired a significant ownership position in Barrick through a third company called TrizecHahn. Barrick arranged an incredible deal where it can massively short gold without any margin requirements for a fifteen year term. On top of this, it can roll over its contracts indefinitely.

According to Doyle, at its height, Barrick accumulated a 23 million ounce short position, which amounted to five times the global investment demand for gold for 2000 and 2001 combined. This is also equal to the combined annual output of every gold mine in the world’s two largest gold producing countries (the US and South Africa), or 80 times the speculative limits set by the COMEX (Commodities Exchange). Doyle claims that all of this was more than adequate to manipulate gold prices downward. Barrick allegedly treated its short positions as off-balance sheet assets and did not feel compelled to include fair market value changes in its current earning statements. It did, however, report $2.2 billion in additional revenue from its short sales. It also reported sixty consecutive profitable quarters of short-selling activity. An unbroken profit record like this is virtually unheard of in the volatile commodities trading world.

Significantly, Barrick unsuccessfully tried to get the case dismissed under the sovereign immunity theory claiming that central banks were involved. This points a finger at the Fed. Also, Doyle said that he thinks a price for gold of $750 an ounce is a reasonable inflation-adjusted number if the suppression had not taken place, particularly given that Barrick began hedging operations back in 1987.

Central bank manipulation of the gold markets is an old story that goes back in recent history to the London Gold Pool episode of the 1960’s. While promoting a guns-and-butter policy that involved simultaneously funding the Vietnam War and his Great Society social welfare programs, Lyndon Johnson wanted to avoid raising taxes at all costs. His administration created fiat money out of thin air and pawned off on foreigners over half the cost of the Vietnam War. (cf. the Mises Institute lecture: ."Presidential Money Mismanagement from FDR to Nixon” by Dr. Joseph Solerno). To artificially suppress gold as a barometer of inflation in order to encourage foreigners to continue accepting dollars as a global reserve currency, Johnson sold off America’s gold reserves through the London market.

America lost so much gold during Johnson’s gold suppression scheme that later in 1971 Nixon decided to close the gold redemption window for foreigners at $35 an ounce rather than devalue the dollar or rein in imports. Within a decade after the Federal Government took the lid off, gold soared to a high of around $850 in 1980 at the height of double-digit inflation.

Fraud note: James Turk reports strong circumstantial evidence that Lyndon Johnson may have foolishly disgorged vastly more of America’s official gold reserves than has been officially disclosed. If true, this would suggest an interesting “the best defense is a good offense” strategy to get other central banks to disgorge their gold in the 1990’s as part of a possible “national security” bureaucratic rationalization to cover up spendthrift recklessness and arrogant unaccountability. Former Swiss Rothschild banker Ferdinand Lips wrote in 2001 in his excellent book Gold Wars: The Battle Against Sound Money as Seen From a Swiss Perspective (footnote 75 to Chapter VII “Betrayal of Switzerland”) that, “Recently, there has been growing doubt whether the U.S. is still in possession of its 261.5 million ounces it declared to be held in trust in the Department of the Treasury. Firstly, there has never been an independent audit of the U.S. gold reserve since 1955. Secondly, in September 2000 a strange reclassification was made in the Treasury Report. Over 54 million ounces of gold were switched from the category of `Gold Bullion Reserve' to `Custodial Gold Bullion' without as much as an explanation. Even more mysterious is the May 2001 Treasury Report where `Reserve’ and `Custodial’ gold have been entirely eliminated and are now labeled as `Deep Storage Gold.' Thus far, the Secretary of the Treasury, Mr. Paul H. O’Neill, has not responded to any questions put to him about the matter by politicians and citizens.” According to William Greider in his classic work Secrets of the Temple: How the Federal Reserve Runs the Country, the Fed has never been subjected to external audit either. Some Treasury watchers think “deep storage” means the US no longer owns this gold. In the case of gold stored at West Point and other sites, it may now belong to foreigners due to gold swap deals. In footnote 20 to Chapter VII, Mr. Lips writes in regard to the decision by Swiss bankers to dramatically reduce their gold reserves in the late 1990’s: “At the time, I was still naïve enough to believe that the Swiss central bankers were motivated by a patriotic interest in the value of the nation’s money. I was wrong. All they wanted was to debase the currency. Throughout the world, central banks are engines of inflation, and they have very little interest in sound money. In fact, and especially in the U.S., the central bank is the creature of the banks. They conceived it, they lobbied for it and, de facto, control it. The purpose of the central bank is not to protect the currency, but to protect the banking system.”

According to Gold Anti-Trust Action Committee (GATA), in the 1990’s central banks sold or loaned out over half their reserves to fill the supply deficit in gold that has existed since 1987. The deficit became 1,000 tonnes a year by 1996, and according to GATA head Bill Murphy, now stands at around 1,400 tonnes. In the introduction to his 1998 Gold Book, Frank Veneroso commented: “Statements by Eddy George, Governor of the Bank of England, and Dale Henderson, staff director of the U.S. Fed have disparaged gold as a reserve asset. The prospect of a never-ending crushing supply of official gold now terrifies all the bullish advocates of gold and makes the bears supremely confident.”

An important part of the intellectual cover for the gold sales was the trend by various European countries to form a European Central Bank by 1998 and merge their currencies into the euro. Obviously if the German Mark, French Franc, Dutch Guilder, and other expressions of nationalism were things of the past, then various European central banks required less gold to help defend domestic finances.

Ferdinand Lips describes in his book Gold Wars how various international organizations used a variety of measures to help knock the Swiss off their former Constitutional gold standard and encourage them to sell their gold reserves in the late 1990’s. The measures included propaganda that gold is obsolete, veiled threats against Swiss overseas banking interests, initiatives to feed the world’s hungry with gold sales, and complaints over fifty years after the end of World War II that the Swiss harbored “Nazi gold.” Mr. Lips feels that the latter charges were unjust, and claims that during the 1950’s the Swiss bent over backwards to identify, compensate, and otherwise help Holocaust victims.

Bill Murphy of GATA claimed in a May 31, 2003 interview with James Puplava that he thinks the Fed has even arranged payments to foreign central banks at prices for gold that are way above current market prices in order to get them to disgorge more gold into the market at below market prices to help keep the price of gold suppressed.

Bill Murphy, Ted Butler, David Morgan, James Puplava, and many other experts who closely follow futures exchanges have frequently commented on supply deficits and overhangs of short positions and derivatives contracts for both gold and silver. Currently total short silver positions that have helped to suppress rising silver prices have grown to 534 million ounces, a decade-long high, or roughly equal to the annual mining supply. Although paper long positions are equal to this, David Morgan claimed on the March 13, 2004 Financial Sense Newshour only about 10% of this sum consists of “registered” physical silver in warehouses available for guaranteed immediate delivery. Another 13% is “eligible” but requires more paperwork for actual delivery. A market that becomes this thin on physical delivery becomes particularly vulnerable when parties such as the Hunt Brothers in the 1970’s or Warren Buffett in 1997 demand substantial physical delivery, which can cause silver prices to skyrocket. Morgan stated in his March 20th FSN update he can see a possible eventual silver price well above $150 an ounce. He cited such factors as severely dwindled above ground silver inventories after a 15 year supply deficit, rising demand for physical delivery, and an eventual reversion of the price ratio of gold to silver to somewhere near its 1:15 incidence in nature. (On March 21, 2004, with $412.12 gold and $7.53 silver, the ratio was 55)

Gold and SilverProduction Deficits and Cumulative Supply Deficits.

[Source: Sharelynx; cf. James Puplava & Eric King's "Believe It!" to use "click to enlarge" feature]

Most futures contracts roll over rather than settle for delivery, allowing interventionists to paper over demand and drive down prices so long as physical supply and demand for physical delivery do not get too far out of alignment. In Gold Wars (Part IV, p. 81), Ferdinand Lips wrote: “As far as the gold market is concerned, it is estimated that the `paper gold’ market in 1999 is many times larger than the actual physical market. Estimates range from a minimum of 90 to an excess of 100 paper-ounce contracts being written for every ounce of physical gold that changes hands. This is not only mind-boggling, or a Frankenstein monster as James Dines calls it, but a king-size horror trip.”

According to GATA, the Fed has the ability to indirectly manipulate both the stock and commodities markets by feeding Wall Street firms money through the repurchase agreement pool. This is about $40 billion in size. The Fed and US Treasury can add another $30 to $40 billion from the Exchange Stabilization Fund totaling $80 billion. Major Wall Street firms can borrow billions of dollars for up to 28 days. The Fed can keep rolling all of this over, as if making a permanent loan. Wall Street firms are free to use this money any way they please, to include using futures contracts at strategic moments to move markets. They can make really big money by following the Fed’s “body language.” Last, but not least, they are highly motivated to remain loyal and sensitive as Fed “team players” in case they some day need an LTCM-style bail-out.

The artificially strong US dollar policy could not go on forever. The dollar has been in decline for the last two years. The initial phase of the US bear market in stocks that ran from March 2000 to March 2003 began to shatter the confidence of foreign investors, whose earlier capital inflows played an important role in maintaining the strong dollar.

Low bond interest rates created by the Fed to prop up the asset bubbles are discouraging additional short-selling in gold. Speculators used to pay .5 to 1% to borrow and then sell gold from central banks, and then invest the proceeds in bonds. Bond rates are now so low that there is no longer a profitable spread. Furthermore, the trend of rising gold prices has made short selling more dangerous. This trend also discourages gold producers from hedging. If anything, the recent trend among producers has been to unwind their hedges.

Even if gold leasing remained profitable for short-sellers, central banks cannot keep selling forever to fill the current approximate 1,400 tonne per year supply deficit. According to Bill Murphy, they may be down to only 10,000 or 15,000 tonnes in reserves. At some point central banks will run out of gold, and world gold prices will skyrocket, making the central banks look even more foolish than they already appear for having disgorged gold well below current market prices in the late 1990’s. In addition, one might ask what might happen if they get rid of all of their gold, and the world goes back to a gold standard?

Despite Barrick’s aforementioned alleged sweetheart deal that allows it to continually roll over its short positions, we can not necessarily assume that all the gold that has been leased out by central banks will be contractually converted into gold sales at lower prices as gold prices continue to move up, or that derivative insurance against rising gold prices will be adequate in turbulent markets. According to John Embry of Sprott Asset Management, “Strong evidence suggests that between 10,000 and 16,000 tonnes (30-50% of all Central Bank gold) is currently in the market. This is owed to the Central Banks by the bullion banks, which are the counter party in the transactions.” Even a very small fraction of short covering in this area could be explosive.

Politically, the European economic integration trend behind the creation of the euro that helped justify gold selling is unraveling. Many countries have balked at taking the last steps towards full integration, and many members of the EU are becoming increasingly restive over their inability to follow independent economic policies. As Mises Institute senior fellow Dr. Hans-Hermann Hoppe points out, the EU has often simply added increasing layers of regulation rather than helped to simplify and standardize regulations throughout Europe. Friction created by Third World immigration and other issues that fuel nationalism could motivate EU members to recreate their own currencies and other tools of national sovereignty.

Rising global gold demand is also putting gold suppression on the defensive. Russia has been accumulating gold, and according to John Embry there are rumors that far eastern central banks are quietly buying gold as well. Countries with large US dollar trade surpluses can do better buying gold (short of running up the gold price) than buying US bonds. US debt instruments can lose market value two ways for foreigners if the dollar continues to decline and if interest rates start moving back up. Both trends are highly likely.

Last, but not least, the strong bull market in commodities fed by Asian demand over the last two years appears to be pulling gold and silver along with it. On his web site Le Metropole Cafe and in his 6 March 2004 interview with James Puplava, Bill Murphy of the Gold Anti Trust Action Committee has been banging the table for silver, claiming that physical above ground inventories of silver are very nearly exhausted. He claims that there is evidence that China has contracted for 75% of annual silver production in 2005. Explosive upward movements in silver could help fuel speculative demand for gold.

If we apply a 5% a year or 28% total increase factor to $400 gold, that brings us to $512 an ounce for gold at the end of five years. This returns us to the technical support base shown in the Gold Newsletter chart for 1993-1995. Frankly I think it is highly likely that we will see $512 gold within one to two years, not to mention five years, but I am trying to be conservative here. The Gold Newsletter price scale is probably conservative to the extent that it uses understated official CPI numbers.

The U.S. is still running balance of trade deficits of around 5% of GDP. This has historically marked the danger zone for a currency crisis. Chinese and Japanese central bankers could easily sink the dollar overnight by simply conducting “business as usual” in global currency markets, that is, by simply selling off their huge trade surplus holdings. Instead, the dollar has made a gradual decline over the last two years only because of their active intervention. This is putting an increasing strain on their economies while rapidly growing trade within the Australia-Asia area provides an increasingly attractive alternative. As an example, Japan spent the equivalent of $180 billion buying depreciating dollars to protect companies against a rising yen in 2003. This was twice Japan’s trade merchandise surplus and about 50% more than what Japan has received for its exports to the U.S. in each of last two years. In mid-March of this year Japan signaled that it might dramatically reduce support for the dollar.

As I discuss in Part II, the rise in the price of gold in dollars against the dollar decline over the last two years has actually been more of a dollar bear market than a gold bull market. But as China and various First World countries continue to inflate their currencies to help maintain export competitiveness to the U.S., this may create a global inflationary bull market for gold as well as undermine the ability of the US to correct its balance of trade problems. We could wind up with a global inflationary bull market for gold on top of a continuing dollar decline bull market for gold.

Professor Tim Congdon’s 2002 World Gold Council research report describes how the US would need to convert 5% of GDP to exports just to stabilize its current account deficit growth with GDP growth. He cites several independent research reports that predicted a 25-50% dollar slide necessary to begin to find equilibrium. He presents formulas that describe how achieving equilibrium is positively correlated with GDP growth and negatively correlated with debt size and interest rates. Since we still have a 5% deficit despite the dollar decline in the last two years, the 25-50% decline projection may still be a valid forward-looking estimate.

In my Oct 29, 2003 article: “Templeton Trepidations, Buffet Battle Stations” I discuss why Warren Buffett divested his firm of $9 billion in US Treasuries and made massive purchases of foreign currencies, and why John Templeton has remained out of US bonds and invested in Canadian, New Zealand, and Australian bonds. Templeton believes the dollar is likely to slide further, although he is unwilling to quantify his views and comment on an Economist Magazine special report that expects a 50% dollar decline.

There are two major issues involved with a sharp decline in the dollar. One is that America has lost so much of its manufacturing base that it may take much longer than in the past for it to overcome its structural problems and benefit from cheaper export prices. An even more serious concern is the possibility that a rapidly declining dollar could lead to many out of control vicious circles.

A rapidly declining dollar might scare foreigners, who may in turn accelerate their disinvestment in American bonds and stocks, accelerating a dollar decline even further. To lure foreign investors back, who buy about half of the Federal debt, the Fed will be forced to raise interest rates. This can cause the stock market to decline further, scaring away even more foreign investors, and putting even more downward pressure on the dollar. In essence, America could experience a crisis involving a plummeting currency, skyrocketing interest rates, and crashing securities markets. This sort of macroeconomic behavior has been an all too familiar pattern with many spendthrift Latin American countries in the past few decades.

To add insult to injury, any sharp dislocations of the currency markets or other markets might trigger another crisis similar to the Long Term Capital Management (LTCM) meltdown in 1998. Robert Moriarity of 321gold.com commented in his March 13th Korelin interview that global debt now stands at $100 trillion, more than twice the world economy of $45 trillion. Even worse, the Bank of International Settlements (BIS) reports total derivatives at $207 trillion, or a little under five times the global economy. They have grown from zero in 1971 when Nixon completely de linked the dollar from gold. Derivatives help institutions hedge currency risk (previously dealt with through the simple use of gold) and also allow them to pawn off risk, leverage speculative positions, and avoid regulatory obstacles in building loan volume. Adding further to instability, we now have record bankruptcies in America in a supposedly benign environment with record low interest rates. Moriarity observed that since Bush was elected, America has lost three million jobs, and the countervailing gain of 750,000 jobs has been almost entirely in the public sector. If interest rates start moving up, and if we also see increasing instability between markets, this could help trigger a broad economic crisis and a derivatives meltdown far too big for the Fed or any other central bank to contain.

In choosing a dollar decline factor, I have selected the low end of Dr. Congdon’s research and am using a factor of 5% a year or 1.28% total over five years. In this case it may be more reasonable to be conservative, since there may be overlapping, interactive effects with the 28% factor that I use for M3 growth that I describe next.

Charts that tell a big part of the story. [source: Grandfather Economic Report].

In the long run price inflation is a function of money supply growth in excess of productivity growth. The Fed has been increasing the money supply 8-10% a year over the last five years. This is about the same rate as during the Lyndon Johnson and Richard Nixon eras which directly preceded the double-digit price inflation of the late 1970’s. Real productivity growth has been in decline over the last few decades and now stands around the .75% to 1.5% area. America now requires five dollars of increased debt to grow a dollar of GDP, and savings (the traditional basis of capital formation) is at record lows.

Aggressive price inflation is already here. Congressman Ron Paul noted in a recent press release that broad indexes show commodities have risen 49% since last spring, and that government CPI figures under-report inflation by focusing on rent figures softened by displaced demand for housing stimulated by artificially low interest rates while ignoring rising housing prices. Al Korelin noted in his March 6, 2004 Korelin Economics Report interview with Bill Murphy that so far in this commodities bull market steel is up 160%, aluminum up 50%, copper up 120%, and lumber is up 93%. Murphy noted that oil appears headed for $40 a barrel. He added that while the indices are screaming inflation every place, the administration comes out and says there is no inflation, and people accept it. “It is ludicrous, inflation is roaring, and Ron Paul is correct…In the CPI there are things they say they do not count such as food, energy, and then we have housing. So if you do not live any place, eat, or drive any where, then there is no inflation.”

Aggressive money supply growth is a longstanding trend likely to continue. In his June 16, 2000 article “Lies, Damned Lies, and the CPI.,” Adam Hamilton explains how M3 has grown at a 7.9% compounded rate since 1959 vs. 4.4% for the CPI. Fed Governor Ben S. Bernanke remarked in Nov 2002 that the Fed is prepared to inflate without limit if necessary.

Total Federal, state, and local government spending continues to grow four times as fast as the economy, especially now that the Federal government is running fiscal deficits that are approximately 5% of GDP to help fund its global war on terrorism. This absorbs additional global savings on top of America’s other “twin” deficit –the balance of trade deficit.

We are also likely to see aggressive M3 growth to handle other rising costs. These other costs may include rising energy prices (discussed again in a later section) and increased costs related to protectionism.

Rising oil and gas prices are an increased cost on the American consumer. They typically reflect a combination of increased taxes to the government and increased transfers of wealth to foreigners, since a little over two thirds of our oil is imported.

We are likely to see rising protectionism as a political reaction to continued job loss to China and other Asian countries. America has lost half its manufacturing jobs in the last three decades. Unfortunately both the timing and the nature of the new “protectionism” will likely increase drag on the economy, putting more pressure on the Fed and US Government to create even more money to try to make up for shortfalls.

Fraud note: The “free trade” vs. “fair trade” national media debate regarding protectionism usually glosses over the most important issues, namely taxation and self-determination. Instead, the debate tends to pay homage to liberal internationalist ideology or pork politics. Protectionism means more tariffs, which at root are nothing more than sales taxes on foreign goods. All taxes are bad, to the extent that they wind up picking the pockets of the productive, real job-creating private sector and transferring wealth to the often wasteful, economically incompetent, and politically warped public sector. It is true that tariffs can be a least bad form of taxation and can comprise an important tool to steer business and reinvestment towards local industry while creating barriers towards countries considered too alien, duplicitous, or otherwise threatening for full social and economic integration. But despite all of this, tariffs remain costly. The Federal Government may wind up raising overall costs to society for the wrong reasons while it is already over-indebted and financially stressed.

In terms of raising revenues, the government has little room left to raise taxes to fund its runaway spending and massive debt obligations without throttling the taxpayer goose that provides the tax eggs. Total federal and state taxes on the average American are about 50% of income.

Cutting government expenditures is getting politically tougher. About 60% of Federal spending involves non-discretionary transfer payments and social entitlements. Although the official national debt at around $7 trillion currently stands at around 70% of GDP, this does not take into account over $44 trillion in un funded current liabilities for Social Security and Medicare that will start becoming a cash drain on the system once the first wave of baby boomers begin to retire in a few years. Demagogic politicians are likely to try to raise taxes anyway, just as they did in the 1930’s to “spread the wealth.” They are likely to seriously undermine the capital formation process needed to create more jobs and wealth, just as they did during the Depression. And of course if they see that their policies are not working, their answer to everything is usually always to print more money.

The Fed is not only creating money out of thin air to support runaway government spending, but it is also fueling credit growth with historically low interest rates to try to prevent collapsing bubbles in the bond, stock, and housing markets. It uses open market operations to buy bonds to help keep interest rates artificially low, monetize debt, and inject more money into the system to help keep the asset bubbles inflated. All of this also causes consumer prices to continually rise.

Foreigners are beginning to ditch dollar reserves. Washing dollars back at the US can only add to price inflation. Half of the $18 trillion in global US dollars are held outside the US . About 68% of global central bank reserves consist of dollars. According to a Lehman Brothers analysis, in the last half of 2003 as much as $133 billion of foreign exchange reserves in non-Japan Asia out of $2 trillion total left the dollar for stronger, higher-yielding currencies such as the euro, pound, and Australian dollar. Asian banks financed half the current account and fiscal debt last year.

Vladimir Putin met with German Chancellor Gerhard Schroeder in Oct 2003 to discuss switching oil sales from dollars to euros. James Turk claims that OPEC countries are already tacitly pricing in euros. Many Islamic countries have threatened to convert to a gold-based Dinar in protest against America’s interventionist policies in the Middle East and also as a defense against the declining value of dollar reserves.

The next shoe to drop will probably take place when foreigners cut back their purchases of America’s fiscal debt issues and stop supporting its current account deficit. At that point the Fed will need to start raising interest rates to help lure foreign investment back. It will also need to print even more money to handle rising interests costs on the national debt. In addition, it will need to monetize portions of its own debt that foreigners and other investors are no longer willing to purchase. The Fed will likely repeat the same pattern of behavior that it showed in the stagflationary 1970’s, in which it was slow to hike interest rates to head off inflation that got into the double digits. This created a real negative interest rate environment that lasted nearly a decade.

As discussed in Part II to this series, gold tends to perform particularly well in a negative interest rate environment. We are likely to experience double-digit inflation, if not hyperinflation, within this kind of environment some time over the next five years.

I think that it is likely the Fed will continue to grow the money supply by at least 10% a year for the next five years. 10% compounded over five years gives us an increase factor of 61%. To be conservative, I have used under half that number, or 28%, suggesting a 5% average annual compounding rate. This is lower than the historic M3 growth rate of 7.9% identified by Adam Hamilton since 1959. However, in the long run M3 growth and the dollar decline factor discussed in the prior section have a high correlation, so a lower multiplier factor intuitively helps to adjust for the overlap between these two variables.

Estimated increase factor: 2% a year or a 10% cumulative total in five years

Newmont President Pierre Lassonde commented in his July 7, 2002 interview with Tim Wood of Mineweb.com that, “…Further, gold production is expected to decline by about 2-4% a year through 2010. Most ‘marginal’ projects have already been factored into the supply and demand balance. In addition, with exploration expenditure levels at record lows during the last five years, there are very few projects of any size that are ‘sitting on the shelf’ waiting to be developed. What we are seeing now is the logical result of the exploration budget cuts over the last five years - a dearth of new projects awaiting development.”

John Embry, President and Portfolio Manager of the top-performing Canadian Sprott Gold and Precious Minerals Fund, stated in the Sept 20, 2003 update of his Fundamental Reasons to Own Gold, “…Mine supply will contract in the next several years, irrespective of gold prices, due to a dearth of exploration in the post Bre-X era, a shift away from the high grading which was necessary for survival in the sub economic gold price environment of the past five years and the natural exhaustion of existing mines.”

Lastly, a Nov 2002 Worth Magazine article reported that the World Gold Council estimates mine supply is likely to decline 3 to 5% over the next few years, and noted that the average mine has a life of 10 to 15 years. Government permitting, community negotiation, feasibility studies, engineering reports, and environmental procedures often stretch out mining projects as long as 5-7 years from discovery until production.

If we factor in the impact of the lack of new exploration over the last five years, as well as the impact of delays in permitting over the next five years, and add on to this the impact of a substantial decline in mining production due to normal mining life span expirations over the next five to ten years, it seems conservative to use a 2% annual gold price appreciation factor for a cumulative five year total of 10%.

INCREASING ASIAN AND OTHER GENERAL INVESTMENT DEMAND FOR GOLD AND COMMODITIES

Estimated increase factor: 3% a year or a 16% cumulative total in five years

As previously mentioned, the Commodities Research Bureau (CRB) index, composed of 17 different commodities, is up over 42 % since Oct 2001. Gold and silver tend to participate with broad moves in commodities, as they did in the stagflationary 1970’s. Recently the charts show commodities and gold moving together.

Growing demand for industrial goods by China, India, and other Asian countries has been putting upward pressure on a wide variety of commodities, to include copper, zinc, and iron. China claims its growth rate reached 9% in 2003, and its raw material demand is tying up 25% of global bulk shipping capacity.

In regard to investment capital, excess liquidity from the Fed and other central bank stimulus is flowing out of paper assets and into commodities, particularly in a negative interest rate environment. On top of this, China has opened a National Gold Exchange. Gold demand in China among its 1.2 billion people could reach 500 tonnes in the next few years.

Global investment demand may be enhanced in the years ahead on an individual investor level by the creation of easier ways to buy and sell gold through such means as stock exchanges and online accounts. In addition, rising gold prices can help to stimulate new demand from momentum investors and investors who feel that rising prices enhance gold’s aura as an investment vehicle and as a natural form of money.

More high-level policy makers are talking about remonetizing gold. According to John Embry,”Islamic nations are investigating a currency backed by gold (the Gold Dinar), the new President of Argentina proposed, during his campaign, a gold-backed peso as an antidote for the financial catastrophe which his country experienced and Russia is talking about a fully convertible currency with gold backing.”

Rising energy prices have a double impact. They help boost commodity price indices, which can help drag gold and silver along. As mentioned earlier, they also increase costs to Americans, and put pressure on the Fed to monetize debt to handle Federal tax revenue shortfalls as taxpayers get squeezed. There is a chance that oil prices could climb as high as $50 a barrel within a year or two. Chinese and Indian demand remains in a steady up trend. Meanwhile on the supply side, Saudi Arabia, which has been the world’s largest producer, is beginning to show signs of maturing production, to include increased water shows in its wells. OPEC members inflated their reserve numbers in the 1980’s in an effort to increase their export quotas and may be at peak capacity and facing decline curves sooner than expected. America passed the point where it can find new reserves to replace current production in the 1970’s. The U.S. now imports around two thirds of its oil. Technical data collected by industry veteran Jean Laherrère suggests that proven and probable world oil reserves are on a decline curve.

Investment guru Doug Casey thinks that the trend of steady growth in Chinese demand could see some near term retrenchment. China claims it has a Non Performing Loan (NPL) problem in its banking sector. In contrast, goldinsider.com editor John Lee disagrees. Over the long run both remain very bullish on China. A factor of 15%, reflecting a little under 3% growth a year, seems conservative, all considering. This may be especially true if we factor in possible rising demand from momentum investors if gold maintains its upward trend.

This is the most difficult factor to assess, since it is based on a subjective assessment of the likelihood that any of a growing variety of “accidents-waiting-to-happen” will in fact take place.

Both gold bullion and gold stocks comprise relatively thinly traded markets that could skyrocket with sudden massive investment demand. The total world gold supply is 4.75 billion ounces. At $400 an ounce, is worth $1.9 trillion. This is only 20% of America’s GDP, and worth only 10.5% of the estimated $18 trillion dollars in existence at home and abroad. The total market capitalization of all the gold mining companies in the world combined is somewhere close to $100 billion. This is less than half of the current market cap of Microsoft.

The derivatives market has swollen to an estimated $207 trillion and is vulnerable to system failure. Nothing has changed since the Long Term Capital Management melt-down in 1998, except that the total quantity of unregulated derivatives has multiplied. Warren Buffett has called derivatives “Weapons of Mass Financial Destruction.” The ability of major investment firms to clear their derivatives positions could be imperiled by a crisis that changes the liquidity characteristics of financial markets. In addition, major financial institutions are more leveraged today than ever before. If a major institution such as JP Morgan Chase goes under, the Fed may have to hyper inflate to provide a back up.

America has increased its open-ended military commitment that could lead to new quantum increases in expenditures. The U.S. Government has already experienced a quantum increase in expenditures since 9/11 that rule out a balanced budget and show Anti-American forces in the Middle East may become more effective in inflicting escalating costs. Any of a number of incidents, such as the possibility that Pakistan (which has nukes) or Saudi Arabia (which has the largest oil reserves) could fall into unacceptably hostile hands might cause further military interventions. Throughout history, war has often lead to unintended consequences and unexpectedly long campaigns that have in turn led to ruinous hyperinflation.

Foreign creditors can force a major crisis simply by pulling the plug. As discussed previously, the US trade deficit at 5% of GDP has reached the point that normally triggers a currency crisis. Foreigners can increasingly deliver shocks to America through passive resistance rather than active measures, to include repudiating the dollar as a reserve asset. Unfortunately current trends may create vicious circles in this area. In his Dec 8, 2003 editorial “Paper Chase,” James Sinclair noted that the Patriot II Act, which does not require due process for the US to seize foreign assets, is already inducing foreigners to start pulling their money out of the US. As America loses more jobs overseas, this increases pressure on politicians to promote forms of protectionism that could risk provoking devastating forms of trade or investment retaliation. A financial crisis could easily force the Fed to hyper inflate.

Failure to turn around deteriorating macroeconomic trends. Time has become America’s enemy rather than its friend so long as America continues to show that it is incapable of turning around serious deteriorative trends. Its real un funded liabilities (to include Social Security and Medicare) are over five times GDP, well over the 120% of GDP threshold often seen as a liquidity trap tripwire. Rising interest rates could trigger a compounding effect that could make total bankruptcy inevitable.

The 2% a year or 10% cumulative five year value I assigned is meant to be a minimal “marker” value to give this factor some visibility. Over the next five years the impact of this factor could range from zero to a figure well over 200%. No one knows. However, even if none of the aforementioned accidents waiting to happen take place, growing levels of vulnerability and instability could nevertheless increase investor anxiety, which in turn could increase the value of gold as an alternative investment vehicle.

Self-sufficient attitudes in 1836. Volunteers from Tennessee, South Carolina, Mississippi and elsewhere in America help Texans achieve greater local autonomy without Federal government or central bank intervention.

The biggest boost to gold prices might come about if gold were remonetized, that is, all or part of America were to return to a gold standard reminiscent of the 1800’s. We have already seen some small but important steps in this direction with such examples as the development of online GoldMoney, or the recent introduction by New Hampshire State representative Henry McElroy of the Sound Money Bill (HB 1342) that would allow people to transact with the state government using US-minted gold and silver coin.

As I explain later in this series, the decline of gold and silver as money has had an interesting inverse correlation with the steady growth of Federal monopoly power since 1861. Perhaps we can call this period a 143+ year bull market in “government” (Federal and state). This federal and state government bull market has expanded its share of GDP from less than 5% in 1861 to over 42% today. In my opinion, much of this has to unravel on many different levels, to include various social, political, and ideological levels, in order to see a full remonetization of gold and silver.

If in fact government hits a financial wall and a huge unraveling process does take place, Americans may be forced on a local level to return to many of the self-sufficient, pro-hard money, and anti-centrist attitudes and values held by the pioneers who once created the Lone Star Republic in Texas, the Grizzly Bear Republic in California, and the provisional government of the Oregon Territory. Come to think of it, this may not be such a bad thing. Under the gold standard, the dollar appreciated 50% by 1900 compared to 1800, despite the inflationary Civil War, and America enjoyed noteworthy periods of economic growth, innovation, rising living standards, and declining interest rates.

It is interesting to try to compare data from the gold standard era to today. According to Franklin Sanders, in 1861 an ammunition plant supervisor in Memphis, TN made 11.3198 ounces of gold a year. At $400/oz gold, that is $4,527 a year today. In 1997, the average small arms ammunition plant production worker made $31,914 a year. Even if we assume living standards have gone up let’s say about two and a half times, that still leaves gold room to triple from here, particularly if gold is remonetized.

It is also interesting to note how debauched the dollar has become since the creation of the Federal Reserve in 1913. According to Dr. Murray Rothbard’s book America’s Great Depression, (page 91), the total money supply in America on June 30, 1921 was $45.3 billion. This was roughly twice what it had been in 1913 as a result of World War I inflation. The expansion from a monetary base somewhere around $20-$30 billion dollars in 1913 to around $16 trillion global M3 dollars today might represent a staggering increase of perhaps as much as 400 times. In contrast, gold at $400 is up only 19.4 times from its $20.67 peg under the old gold standard. (I provide these numbers for rough comparison purposes, since “total money supply” for mostly domestic use in 1921 may have had a very different meaning than globalized “M3” today).

Imagine if we were to try to go back to a 40% reserve policy similar to the 1800’s, and if we were to use a gold price of $400 to try to figure out how many ounces we need as reserves in America’s vaults:

We have a problem here. There are only 4.75 billion ounces in existence above ground on the planet. Obviously we would have to drop our reserve ratio and/or increase the price of gold dramatically.

Let’s say we could get our hands on every ounce of gold on the planet. We would then need to raise the gold price 3.78 times to $1,516 an ounce to back up 40% of existing dollars.

Let’s say the US Government decides to back up just 20% of its dollars with gold. Then, lets say that it gets its hands on 10% of the world’s total 4.75 billion ounces of gold as a back up, even though America currently has an approximate 25% share of global GDP. Here is what the calculation would look like:

This calculation is meant simply to aid the reader’s intuition about how almost any feasible assumptions that we apply to a model regarding remonetization of gold is likely to see a whopping increase in the gold price.

There are obviously other complicating factors that could apply in the real world. As one example, if other countries around the world adopt a 100% gold standard, the world market price for gold could skyrocket above our theoretical reserve price and help dictate to America a price reflecting a 100% reserve ratio. On the other hand, all things being equal, we might be able to afford a lower reserve ratio for gold if we introduce other forms of commodity money such as silver that could compete with gold-related money.

In the early 1800’s Americans used silver certificates and silver coin as much, if not more, than gold. In his series “What Has Government Done to our Money?” Dr. Murray Rothbard suggested pegging the dollar to gold, while simultaneously allowing silver and other forms of commodity money to “float” with the free market rather than get pegged in a specific exchange ratio to gold and the dollar.

There is no one right answer. As a historical reference point, while America was on a “gold-plated” standard in the 1800’s, banks were required to back up 40% of their currency with gold. The same was true of most countries around the world during that era. Switzerland used a 40% reserve ratio until it dropped its gold standard in the late 1990’s. As I describe in a later part of this series on the history of gold in America, within a decade after the Federal Reserve Banking system was created in America in 1913, the gold reserve ratios in banks across the country plummeted down to the single digit level. Faith in back-up by the “Fed” replaced faith in a gold “back up.”

The equation above shows that the lower the reserve ratio we try to use, the lower the price of gold that we can set. However, the lower we try to set a reserve ratio, the more we increase the risk that any particular run on the financial system could quickly deplete all the gold reserves. So this is really a situation involving trade-offs between intangibles. On the one hand we balance “confidence” in the overall integrity of the banking, financial and economic system against the depth of our gold reserves to endure a run on our currency should people begin to lose confidence.

There is a paradox here similar to spending on national defense. Theoretically, the more a country invests in gold reserves and spends on national defense, the less likely it will be that it will ever need either for defensive purposes.

Let us first look at the current official U.S. gold reserve situation. According to the World Gold Council, the U.S. as of Dec 2003 had 147,800 tonnes of above ground global gold existing (Goldfields, end of 2002). If we use 5% of world gold as a reserve for 20% of 18 trillion in global dollars, that means that we would need to set the gold price at $15,157 an ounce.

There are a number of factors that make a calculation of an appropriate percentage of total gold that would be necessary to back up the dollar really tricky. Intuitively it would seem that if the US has 25% of global GNP, it should obtain about 25% of the world’s gold. However, 25% of world gold seems totally beyond the pale given circumstantial evidence described by James Turk that the US may not even have even a small fraction of the 5.5% of the world gold supply that it claims it has. Given the thinness of gold markets, if in fact the U.S. is out of gold, making purchases just to get back to 5% could be a nightmare.

The ultimate focus should be on restoring the free market and taking money out of the hands of government, not the particular dollar peg price for gold.

In Part VI titled “The Propaganda War Against Gold” I describe Dr. Murray Rothbard’s argument that it does not matter what particular price is used as a peg for gold under a gold standard as long as it reflects an equilibrium free market price for gold and a reasonable relationship between the supply of gold held in reserve and the supply of dollars. Once the dollar gets fixed against gold, it becomes “as good as gold,” and the system can function just as effectively if a dollar reflects .00025 ounces as if it were to reflect a different ratio that has more decimal places. The main concern is that the system is created with sound free market pricing relationships to begin with.

The biggest issue involves creating and maintaining a stable monetary system out of the hands of politicians. It also involves creating fairly constant monetary reference points that become the basis of a “galaxy of prices” that aid entrepreneurial calculation and help avoid economic imbalances. More on all this later in this series.

I agree with Texas Congressman Ron Paul that there is a strong likelihood that the United States Government will eventually hit a financial wall. Although this probably will not happen tomorrow morning, it is possible that it could happen as soon as within the next five to ten years. There are increasing numbers of wild cards in the hands of foreigners that make the near term odds almost unknowable.

I originally thought it would most likely happen at the end of the next likely credit bust cycle, say around the years 2030-2040, by extrapolating from the Dow/Gold ratio chart near the beginning of this article. Given current demographic trends, the 2030-2040 era might mark a tipping point where most Baby Boomers have died off and America becomes an extremely unstable hodgepodge of disparate, unassimilable, and majority “Third World” peoples, as envisioned in Peter Brimelow’s classic work Alien Nation. However, the ability of Bush, Greenspan, Neo-Cons, & Associates to fast-forward the imperial overstretch, profligate spending, and alienation process has impressed me enough to revise forward my estimates.

To gain some insights into a “terminal drop” process that took a seemingly monolithic system by surprise, in the year 2003 Lew Rockwell, Director of the Mises Institute, invited former Soviet leader Mikhail Gorbachev as a speaker. (cf. Rockwell’s talk “How States Fall and Liberty Triumphs”). Rockwell claims that Gorbachev really tried to save the old Soviet system. He tried to give the appearance of leading reform rather than reacting to it. As Rockwell puts it, before violent oppression by Gorbachev became a viable option to maintain the old system, he was “run over by history and out of a job.”

In Part XI of this series I will try to examine various scenarios in which remonetization of gold and silver could take place alongside various possible restructurings of the social and political order in America in the event that such 20th century institutions as America’s central bank and its ever-expanding fiat money and credit creation system get run over by history.

Bill Fox is VP/Investment Strategist and private client money manager, America First Trust. Bill welcomes phone calls and responses to this article. His web site: www.amfir.com. Address: VP, America First Trust, Reg. Rep., Sammons Securities Co., LLC P.O. Box 820669, Vancouver, WA 98682, telephone: 360-882-5369, toll free: 866-945-5369 (866-WILL FOX), email: wfox@sammonsrep.com. Securities offered through Sammons Securities Co LLC, member NASD and SIPC. © 2004 Bill Fox. Additional Disclaimer: Not all views referenced in this report are necessarily those of the author, America First Trust Financial Services, or Sammons Securities Co., LLC. Sometimes the author provides opposing viewpoints to give the reader a greater sense of perspective. This report is intended for informational purposes only and should not be considered specific investment advice. It is not intended to be a recommendation to buy or sell securities in the absence of specific knowledge regarding the financial situation and suitability requirements of a reader. The information has been obtained from sources believed to be reliable but whose accuracy cannot be guaranteed. Past performance is no guarantee of future results. There can be no guarantee that the market will perform according to the author's opinion or that his investment ideas will be effective under all market conditions. His opinion can change without notice. Investment returns will fluctuate and the value of an investor's positions may be worth more or less than the original cost when redeemed. Market data presented here is subject to change daily. Sammons Securities Co., LLC is a member of the National Association of Securities Dealers (NASD) and the Securities Investor Protection Corporation (SIPC).

DISCLAIMER: Not all views referenced in this report are necessarily those of the author, America First Trust Financial Services, or Sammons Securities Co., LLC. Sometimes the author provides opposing viewpoints to give the reader a greater sense of perspective. This report is intended for informational purposes only and should not be considered specific investment advice. It is not intended to be a recommendation to buy or sell securities in the absence of specific knowledge regarding the financial situation and suitability requirements of a reader. The information has been obtained from sources believed to be reliable but whose accuracy can not be guaranteed. Past performance is no guarantee of future results. There can be no guarantee that the market will perform according to the author's opinion or that his investment ideas will be effective under all market conditions. His opinion can change without notice. Investment returns will fluctuate and the value of an investor's shares may be worth more or less than the original cost when redeemed. Market data presented here is subject to change daily. Sammons Securities Co., LLC is a member of the National Association of Securities Dealers (NASD) and the Securities Investor Protection Corporation (SIPC).

Inflation	Deflation	Commodities	Silver	Gold
1808-1814		+58%	-33%	-37%
	1814-1830	-50%	+89%	+100%
1843-1857		+48%	-30%	-33%
1861-1864		+117%	-53%	-6%
	1864-1897	-65%	+27%	+40%
1897-1920		+232%	-49%	-70%
	1920-1933(Ascani)	-69%		+251%
1929-1933		-31%	-5%	+44%
1933-1951		+168%	-4%	-37%
1951-1979		+158%	+380%	+240%

1933-1997(Ascani)		+1013%		+51%