Gold Investments Weekly Newsletter
28th February 2005
Mark O'Byrne
Weekly Commentary
Why should Irish, UK and European investors invest a small percentage of their investment portfolio in gold and silver?
There are a myriad of fundamental reasons that European investors, institutions and Central Banks should continue to diversify a small portion of their assets into precious metals. These include rising interest rates in the world's largest economy; record consumer, mortgage and national debt levels in the US & much of the western world; huge and unprecedented US trade and budget deficits and dwindling supply of and increasing demand for precious metals.
Two other fundamental factors to consider are the decline and depreciation of the US dollar and the rise of oil prices.
The dollar is currently the primary global reserve currency. To explain how this relatively recent monetary phenomenon came about I defer to this succinct explanation by John Mauldin, President of Millenium Wave Advisers: "The first Bretton Woods system came about when representatives of most of the world's leading nations met towards the end of World War 11 at Bretton Woods, New Hampshire, in 1944 to create a new international monetary system. Because the US at the time accounted for over half of the world's manufacturing capacity and held most of the world's gold, the leaders decided to tie world currencies to the dollar, which, in turn, they agreed should be convertible into gold at $35 per ounce.
Under the Bretton Woods system, central banks of countries other than the US were given the task of maintaining fixed exchange rates between their currencies and the dollar. They did this by intervening in foreign exchange markets. If a country's currency was too high relative to the dollar, its central bank would sell its currency in exchange for dollars, driving down the value of its currency. Conversely, if the value of a country's money was too low, the country would buy its own currency, thereby driving up the price.
The dollar became the world's reserve currency. Yet there were limits. Each country had to police its own reserves and currency or be forced to revalue. And the US was constrained because the dollar was fully convertible into gold. This changed in 1971 when Nixon closed the gold window.
Now we have what many are coming to call a Bretton Woods 2 system. That is where much of the world, but primarily the Asian countries, have more or less informally agreed to peg their currencies to the dollar. They do this in order to maintain their relative competitive ability to sell their products to the world and specifically to the US.
But this system is inherently more unstable than the first Bretton Woods. There is no gold conversion constraint upon the reserve currency. The US has few reasons to protect the value of the currency, and many reasons why they should want it to drop. And there is no formal agreement among the nations. Any nation at any time could begin to act unilaterally to change. Russia has specifically said they would start to have a larger euro component to their growing national reserves. Thailand has said the same, and indications are that they are putting actions behind their words."
Mauldin penned these thoughts only last week and published them on the 19th of February. His thoughts were very prescient as last Tuesday the 22nd, the Bank of Korea caused a sharp sell off of the dollar and uncertainty in financial markets when a senior official said that the Central Bank of Korea would be diversifying out of their huge dollar holdings. Subsequently this was understandably denied.
As of Feb 15, South Korea held foreign-exchange reserves of $200.25 billion, making it the world's fourth largest after Japan, China and Taiwan.
Japan topped the reserves chart at $840.966 billion as of the end of January, according to Ministry of Finance data.
China's foreign-exchange reserves stood at $609.9 billion at the end of 2004, good enough for No. 2 following Japan.
China, like many countries, doesn't reveal the composition of its reserves, but U.S. dollar-denominated assets are believed to account for somewhere between 60 and 80 percent. Should these Asian countries or other countries stop buying US debt instruments or even worse start selling them and diversifying their foreign currency reserves into other currencies such as the euro and even gold it will create difficulties for the massively indebted US consumers, households, companies, financial institutions, states and government.
The New York Times editorialised: " . . . as the Korean comment ping-ponged around the world, all hell broke loose, with currency traders selling dollars for fear that the central banks of Japan and China, which hold immense dollar reserves -- a combined $900 billion, or 46 percent of foreign Treasury holdings -- might follow suit. That would be the United States' worst economic nightmare. Tuesday's market episode has its roots in American structural imbalances that will be corrected only by new policies, not more of the same tax-cut-and-weak-dollar deficit-bloating ploys." In a similiar vein CBS Market Watch article entitled 'South Korea reports raise 'what-if' talk about China', Lisa Twaronite wrote how "reports that South Korea is thinking of diversifying its currency reserves caused market ripples, but a similar hint from China could cause a tsunami. This once again highlights the economic vulnerability of the US. As the world's largest debtor there economic destiny is now in the hands of their creditors - the Chinese, the Japanese, the Koreans, the Indians and the EU. The US is dependent upon the rest of the world's savings in order to fund their massive debt - total credit market debt (government, corporations, and individuals) is at $34.62 trillion and growing. This debt is now three times the size of the annual value of all goods and services in the US or 305% of GDP. On the eve of the Great Depression in 1929 total credit market debt was 260%.
As the current global reserve currency the US dollar's performance against other fiat currencies has massive financial and economic implications for the individual economies of the world and for the global economy. This is especially the case as our global economy has become more integrated in recent years with increasing cross border trade and cross border flows of capital. In this increasingly globalised economy, the performance of the primary means of exchange and payment for commodities, goods and services internationally is of vital importance.
The economic and monetary paradigm of the final years of the 20th Century was a very benign one. The Clinton and Greenspan era of the booming 1990's when the US economy enjoyed tremendous rates of growth, low inflation and the increasing productivity brought about by innovative new technologies resulted in capital flowing into the US and consequently this led to the "strong dollar". With the Cold War over there was far less geopolitical uncertainty and investors, institutions and Central Banks around the world had confidence and faith in US capital markets and the US dollar.
Since 2000 the collapse of the Nasdaq, the Enron and WorldCom accounting scandals, September 11th and the Bush Administrations response to it in the form of the 'War on Terror' and the burgeoning trade and budget deficits have all led to a gradual and growing erosion of confidence in the US dollar and increasingly the US economy itself.
Investors, institutions and Central Banks are increasingly sceptical of the US' ability to correct the massive imbalances in their economy without an economic downturn. This has led to the falling dollar and has become so serious that some respected economic commentators are discussing the possibility that the euro may supplant the dollar as the global reserve currency in the next 10 to 20 years. This may happen in a far shorter time frame were OPEC or the authorities in Russia, Saudi Arabia, Iran and or Venezuela to price their oil in euros. This would likely end the economic paradigm of the petrodollar which has been in place since Nixon closed the gold window in 1971.
Up until 1933 gold was money and every dollar was backed by gold. This meant that dollars were in fact paper gold certificates or promises to pay a certain amount of gold. When Roosevelt ended the gold standard in 1933, he banned the export of gold, halted the ability of US citizens to convert their paper dollars into gold and also ordered a gold confiscation whereby US citizens had to hand in all the gold they possessed (this prohibition on gold lasted until 31 December 1974).
International governments could still redeem their their paper dollars for gold in the post War period and up until 1971.However this link between the dollar and gold was broken unilaterally by the US in 1971 after it had spent many more dollars into circulation internationally to pay for the Vietnam war than it had gold in Fort Knox to back them. Fearing that the dollar's value had become unsustainable, holders led by the French under President de Gaulle rushed to convert them to gold before a devaluation happened. A run on the global bank (the US) began and the manager, President Nixon responded by refusing the holders of the promissory notes the US had issued what they were due. He defaulted by 'closing the gold window', thus ending any fixed relationship whatever between the dollar and gold. This destroyed the key feature of the Bretton Woods system which, in retrospect, seems to have served the world reasonably well. What emerged in its place was a more haphazard arrangement which allowed the defaulter, the world's richest and most powerful country, to reap a massive benefit by creating the majority of the global money supply with no formal constraints at all.
"There can be no other criterion, no other standard than gold. Yes, gold which never changes, which can be shaped into ingots, bars, coins, which has no nationality and which is eternally and universally accepted as the unalterable fiduciary value par excellence." This is Charles de Gaulle, the President of France's famous quote. He realised that the basic laws of nature and economics - the law of supply and demand meant that gold was a safer store of long term value and thus a more trustworthy universal medium of exchange. This is because there are is a finite amount of gold in the world and it takes a lot of money, labour and time to extract the precious metal from the bowels of the earth. Ben Bernanke, Alan Greenspan's likely successor as Federal Reserve Governor recently told us " Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology called a printing press , that allows us to print as many dollars as it wishes at essentially no cost". In effect Bernanke threatened a massive devaluation of the dollar in order to pay for their massive internal and external debt obligations.
While the euro supplanting the dollar would be hugely beneficial to the increasingly powerful European Union in the medium to long term, the transition would undoubtedly be painful in the short to medium term. The dislocations and uncertainty created would likely be damaging to the performance of equity, bond and property markets and result in an increasing flow of capital into the precious metals markets and a consequent increase in prices.
An increasingly strong euro is a double edged sword and confers advantages and disadvantages. A strong euro threatens the recovery of the large European economies. Jean Claude Trichet has called the rise in the Euro both brutal and unwelcome as the Euro zone's fragile recovery is export driven and thus European manufactured goods are becoming more expensive to US consumers and imports into the EU are becoming cheaper to European consumers. Already the two major economies in the Eurozone, Germany and France are experiencing unemployment rates of more than 10%.
Economic commentators such as Stephen Roach, the Chief Economist of Morgan Stanley have warned of a possible 1930's like beggar my neighbour type round of competitive currency devaluations.
Dr. Richard Appel of Financial Insights in an article entitled 'Gold and the broadening spectre of competitive currency devaluations' explains what a global round of competitive currency devaluations would entail: "Throughout modern history, periods of worldwide economic decline have been accompanied by spates of competitive currency devaluations. These have repeatedly occurred during difficult times as country after country, in their effort to gain an advantage over their trading partners, fostered a weakening of their currencies. The hope of each domain has always been that a weaker domestic currency would stimulate world demand for their goods and services. This, they believed, would foster an increase in their output and generate a renewed round of economic expansion. It always began with one nation's attempt to benefit itself, but ultimately spiralled out of control when others followed their lead.
In practice, using currency devaluations to enhance one's domestic economy has never worked for long. The reason is simple. It is one of human nature. What was consistently overlooked was that other governments would not stand by idly. They would not allow a competing country the ability to gain an upper hand and a trade advantage over them. To the detriment of all, the end result of each such experiment has produced animosity between the engaged nations, a worsening of their economic declines, and it has even led to war. It is a glaring frailty of mankind that neither individuals nor politicians rarely seem to learn from the experiences of their predecessors."
Competitive currency devaluations globally as well as higher import prices result in significant inflation and significantly higher interest rates in individual countries. Moreover, the price of gold increases in terms of these competitively devaluing currencies and the assets denominated in these fiat currencies.
This is one of the most fundamental reasons to consider diversifying a small percentage of one's wealth into precious metals.
Disclaimer ; Legal Notice:
The information herein is based on sources which Gold & Silver
Investments Limited believes to be reliable, but we cannot warrant
its accuracy or completeness. Such information is subject to change
and is not intended to influence your investment decisions.
This document is not and should not be construed as an offer to sell or the
solicitation of an offer to purchase or subscribe for any
investment. Gold & Silver Investments Limited have based this document on
information obtained from sources it believes to be reliable but which it has
not independently verified; Gold & Silver Investments Limited make no guarantee,
representation or warranty and accepts no responsibility or liability as to its
accuracy or completeness. Expressions of opinion are those of Gold & Silver
Investments Limited only and are subject to change without notice.
Gold & Silver Investments Limited assume no warranty, liability or guarantee for
the current relevance, correctness or completeness of any information provided
within this Report and will not be held liable for the consequence of reliance
upon any opinion or statement contained herein or any omission. Furthermore, we
assume no liability for any direct or indirect loss or damage or, in particular,
for lost profit which you may incur as a result of the use and existence of the
information provided within this Report.
Opinions expressed at www.goldinvestments.org and www.gold.ie are those of the
individual authors and do not necessarily represent the
opinion of www.goldinvestments.org and www.gold.ie or its management.
The content of this website is the property of Gold & Silver Investments Limited
or its licensors and is protected by copyright and other intellectual property
laws. You agree not to reproduce, re-transmit or distribute the contents
herein.
This article may be reproduced without the written permission of Gold & Silver
Investments Limited as long as the author, Mark O'Byrne and the web sites
www.goldinvestments.org
and
www.gold.ie
are acknowledged.
Please send a message with
"Remove" in the subject line if you wish to no longer receive this newsletter.
Copyright © 2000 - 2005
www.goldinvestments.org
www.gold.ie
Gold & Silver Investments
Limited
Email this Article to a Friend 
Printer Friendly Version