The Coming Depression

June 20, 2003

This following extract of Richard Russell daily newsletters points to the corner stone of the future of the economy. China may win the war and conquer the world, after all, without firing a single bullet.

Richard Russell

Dow Theory Letters snippet

Jun 13, 2003

Extracted from the 12 June 2003 issue of Richard's Remarks

I've been asked repeatedly how the US can possibly face deflation with the Fed dead set against deflation, and while the Fed is using every tool at its command to fire up the forces of inflation.

The answer is that US inflation and the US trade deficit has loaded the nations of the world with liquidity. This outflow of liquidity has resulted in almost every nation vastly increasing its production facilities.

We're now dealing with world over-production. This world over-production is putting pressure on prices from one end of the globe to the other end. The pressure of world over-production is forcing prices (and even the price of labor) steadily lower. This is price deflation, pure and simple.

An interesting case is China, which has become "manufacturer to the world." The 1.4 billion Chinese could easily produce almost all the manufactured goods that the world needs. Furthermore, the Chinese yuan is FIXED to the dollar at a ratio of 8.28 yuan to one dollar. As the dollar weakens, China become even more competitive. So far, the Chinese have ignored the pressure from many nations to allow the yuan to "float" higher. The Chinese like it the way it is, and besides, China has a large unemployment problem. China's leaders know that their best chances of remaining in power is to keep the people employed.

The US is now in the process of losing its manufacturing base to foreign low-priced labor. On top of this the US is building huge and unsustainable deficits. Ultimately something must give and that something is the dollar.

So far, the dollar has been declining in a gentle manner. But somewhere ahead I believe we'll see a panic out of dollars and very probably a panic out of all fiat currencies. The alternative to fiat currencies is gold.

I've said it all along, but I'll repeat it. I think large, informed interests are using this area to accumulate gold and gold stocks at what they consider bargain prices. These people are not anxious to see gold move higher, not now they're not. In fact, I believe they'd be just as happy to see gold move even lower so that it becomes even more of a bargain.

I've been suggesting that my subscribers do the same thing. Use this area to accumulate gold and gold shares and forget about quick profits. This is accumulation time, not "take profits" time. After all, if you sell gold or gold shares here, you're probably going to sell your merchandise for a declining asset, and the declining asset I'm referring to is the dollar.

More follows for subscribers . . .

Richard Russell

Dow Theory Letters

© Copyright 2003 Dow Theory Letters, Inc

All the discussions in the media about inflation versus deflation are hogwash. We have been in a deflation since about 1980, which may very well end soon in a panic (depression - the herding phenomena by which everybody runs for the exit but jumps over the cliff instead). The media have been calling it disinflation, i.e., inflation (CPI) going down. In fact, the media were misled by mainstream economist (paid to propagate?), making people focus on consumer price index being high or low, instead of rising or falling. This is not so important as the rise and fall of interest rates or changes in the flow of money (volume and speed). Interest rates is the cost of money and it determines in part if money flow will increase or not, allowing the banks to carry on with their business. Lowering interest rate of late is equivalent to putting paper money on sale (bargain), dropping money bags from helicopters and so on. The theory has been (Keynes and Friedman) that without the discipline imposed by gold, we can control our paper money supply and demand curve with "more flexibility". However, our greed is such it cannot be done, as history goes. It is beyond our individual and collective will and capacity. Find out why at the end of this comment. We need a mechanical device, an independent referee and a policeman: GOLD. That has been demonstrated historically by the failure of fiat monetary systems and this is why we have come to rely on gold to help us out, as a consequence. It is not important to understand the process (herding again). Gold has imposed itself as if it has its own will and it will continue to do so independently of our will. The human factor (economic and political policies) is a catalyst at best. Unfortunately, we "rediscover" this property of gold being real money the hard way, always. One would think in the 20th century, we'd be doing better with the Internet and so on. Listening to Greenspan self-glorifying public statements, we have not learned our lesson yet.

One thing that interests me is the linkage of gold to paper money and commodity markets beyond what exist in the main stream literature. There is a coming paper by professor Antal E. Fekete that I had the privilege to review that explains some of this in an innovative way. Professor Fekete has been applying Carl Menger theory of price formation to the development of a new theory of the formation of interest rates, i.e., the price of money. In his theory, gold stands out as the only real money. In fact, gold value diverge from all other things (goods and services) because it's marginal utility is almost constant1Reg Howe and al have done similar research linking derivatives to gold, i.e., the price of gold, gold lease rates and historical monetary system failures. Their research is on the edge. It highlights the fact that gold never lost its lustre. It continues to be treated as money by the (free) markets, but it's usage as a regulator of money market and the economy has changed. Nevertheless, it is inevitable that the monetary system revolves around gold, like the earth around the sun.

Falling Interest Rate Induced Bubbles

The Stock Market Bubbles of the 1920's and since 1980 are induced by falling interest rates that eventually leads us into a depression. The falling interest rates when it gets near zero create a Bond bull market that support financial institutions against productive sectors, i.e., industrial investments and job creation. The Bank of Canada today is playing the game contrary to the US Fed and the ECU of continued falling interest rates. Will it pay off?

Call me lunatic or radical, but even gold as jewellery has not lost its property as real money. Jewellery was the wallet of our ancestors and their king's tomb (and our churches) filled with gold, equivalent to central banking system (hoarding gold as wealth, i.e., capital). Some may call my statement profanity, but there is no contradiction in the fact that gold's lustre is considered sacred by some, a commodity by others and it playing a social and economic function as well. Essentially, it is based on converging interest instead of competitive (opposing) interests. In fact, gold as jewellery continue to play this role today. It has the potential all the time and it sure does apply when it is recycled, regardless of the state of consciousness of the bearer of gold jewels. In developing countries were people don't have access to banks, even if they wanted to, they simply sleep with their bank account around their neck. Gold is a traditional gift of dowry, the ultimate protection from abusive husbands and the life insurance required by widows and orphans.

Believing in fiat money without gold as a regulator is like seeing the earth as flat or the centre of the universe. It looks flat as long as you don't get out of you village and travel far away. Even then, you have to look at the moon and the sun and ask yourself serious questions about their shape and shadows they display, like our ancestors did [instead of watching that idiot box we call the TV]. Fiat money is akin the theory of the earth being the centre of the universe. The theory is true if and only if you can pin down the earth and make it stand still. It works. Everything will revolve around us as it always did. We have the tendency to put ourselves at the centre of the universe, but the problem is in our heads. It is a problem of perception. In that case, when we need to describe what is going on around us, we run out of logical explanation as we expand the universe beyond the sun and the moon. We couldn't even explain why we stick to the ground (with gravity), instead of flying into space.

Conversely, we came to use gold as real money as a long natural process without thinking too much (Carl Menger, Principles of Economics). The afterthought, the likes of Sir Isaac Newton who "fixed the price of gold" in the classic gold standard was brilliant or was it? The fact of gold being real money is not the fruit of human intelligence. Given the time and the means, scientific research could demonstrated that gold imposes itself universally, like the theory of relativity is universal, independently of our will. If we landed on another planet with a civilization somewhat advanced like ours, no matter if the people have six or eight arms and one leg, they certainly are using gold as money, as many civilization did on earth independently of each other.

How come? Like I said, we need more scientific research, but it is not a matter of choice. For a starter, we can understand the need for gold better from the gold miner's point of view, i.e., the supplier of gold. My own research has been focusing on the producer side of gold because of my professional background (P. Eng., geology), but I find most people in the gold mining business don't know the value of gold as real money. Now that the Internet embraces the globe, maybe we can put the final pieces of the picture on gold together.

Like everybody old enough, I have observed the apparently absurd increases of interest rates at the same time as inflation (CPI) in the 1970's. Conversely, it seems everybody breathed a sigh of relief when it started coming down in the 1980's, not realizing we entered in a deflation (over production) phase that could turn into the worst economic depression ever seen by mankind2. In that period, gold has been pushed aside in world trade (by the US dollar) and ridiculed while the gold producers entered a race to increase their production at a decreasing unit cost in an attempt to "commodities" gold. This competitive race forced many small gold mines extracting gold from high-grade narrow veins to shut down in the 1980's. Producers looked for open pits gold mining (at lower grades) to solve their financial problems, i.e., a relative low price for gold. Hence, the traditional high-grade (and high cost) underground gold mines automatically got saved for future production. In the 1990's, this situation was not enough to help bankers as gold threatened to compete with fiat money after the demise of the USSR and international monetary crisis were becoming increasingly frequent.

The actions taken by world banks to get some buoyancy were varied and gold was part of the solution. Actually, there was a blip in 1987 after the US dollar took a blow. Greenspan took over at the Federal Reserve from Paul Volcker. In 1987, gold was tested, i.e., leased and/or sold, to increase liquidity in the stock market while maintaining falling interest rates. It worked and the process was generalized in 1995 (conceived generalization in 1993) and used until about 2001 when most of the easy "volunteered" central banks gold reserves were disposed of to make up the difference (~40% deficit) between the gold mine production, including recycling, and the demanding markets (~4,000 tonnes per year). Few people notice that the real target was to keep the price of gold down or, conversely, the price of fiat money up (and the stock market, and the bonds, and the derivatives, and real estate, and credits and debts all up like never in history) and interest rates (and inflation) low. More clumsy but true, the gold producers were sucked into the process of competitive borrowing gold massively (hedging) to finance their expansion into a "dead commodity". What did they do with the gold they borrowed? They sold it in exchange for fiat money… Fiat money is like a bottomless water well. Gold is like an elastic. It has to unwind or it will come right back at you and smack you in the face. Buying gold now is a no-brainer. In 1980 dollar, gold is today selling at $150 per ounce, down from $850. When it snaps back, we should expect a 5 fold increase in its price from today's level just to catch up to 1980's price, hence about $2,000 an ounce. But by then, the US dollar will have decline more, so gold nominal value will continue to grow to $3,000 probably (if the dollar still exist). It sounds crazy, but what has to be understood is the marginal utility of gold, i.e., its exchange value for common commodities (and wages), is relatively stable. It will remain so. That is what makes gold attractive in times of crisis. In other words, it is the amount of work involve into extracting from the ground and pouring an ounce of gold or making a gold coin always compares favourably to other common goods and services.

Why is gold so much real money? People fantasize about gold, its physical properties and so on. Gold is not valuable mainly because of the impact it has on our imagination, i.e., our perception of it. In other words, gold is not valuable because of human psychic ("small and beautiful"). It's physical property of being one of the most heavy metal, easy to recognize, and so on are valuable, but they are found in other material, mostly silver. Of course, gold has all the right properties, but one stands out to me, which is not physical in the unitary object as we see it, but in its quantity and availability (scarcity) in nature. The way gold occurs is a reflection3 of the natural growth of human society both in number and in quality. Unlike most other mineral resources, it does not obey to a linear process. It comes in burst of energy up and down (decay with a long trail), where lognormal process are involved in its setting (Black and Scholes Option pricing theory). The referee or mark to market is not zero like in "zero interest rate is good", but one (1) or maybe e (2.718) should be the central value of reference in fact. Money is not free as in "not paying interest" or near 0% lending rates. In that case, the lender looses his wealth, which has to be at least preserved at a rate equal to the economic growth (population plus technological improvements), say at the rate of e% (e = 2.718)4. That is why gold is real money besides it's physical properties which are advantageous. In my view, we must study the linkage of gold with demographic phenomena, including herding behaviourism, if I may say so, to explain the variance of its value around a long-term constant value reflecting the level of human activity. Gold is the quintessence of value in exchanges of goods and services (banking). More so, gold imposes its discipline according to the laws of nature as in population growth and herding. It is up to us to put those natural laws in our Constitutions and implement them in a smooth manner (or not) to avoid chaos.

Gold Leads Recovery in Commodities

GDP (Gross Domestic Product) includes the effect of price changes (CPI), population growth, money flows (M1, M2 and M3) and technological advances. Using the GDP growth rate to discount the Stock Market Index as a proxy to the value to productive assets, their value hovers around a flat line. On the other hand, gold price is suppressed in periods of "economic growth" in favour of paper assets until it rebounds in a recurring "gold rush" when bubbles burst and the global balance sheet is updated (assets and liabilities relative paper value adjusted with commodity value). The Feds monitor the economy using the GDP closely, but lead the public into paying attention to the CPI as a psychological diversion.

As a population grows, its efficiency grows, so does its technology. Gold production follows that pattern. Hence, my suggestion to replace CPI% with GDP% growth in financial model to actualize the net present value of assets. It transforms the data into a linear function easy to verify. Gold does not withstand abuses, cheating and lying. Its value is constant relative to commodities in general; notwithstanding, it takes more or less fiat money to purchase it in time. But that is because fiat money looses value, not gold. Gold does attract cheaters and liars, like honey attracts flies, not because it is bad, but because it is good, i.e., too good to bypass by anyone's standard, regardless of their moral values. But unlike paper IOU's, physical gold does not lie. In the development of human society, exchange grew and gold as a commodity grew with it with the added function of money all along, all the time. It continues to do so but for the most part it does not go away like everything else. This is why it can act as a store of value, a safe haven, like nothing else, to transmit wealth. It acts as such through space and time and maintains its purchasing power over very long economic cycles (~30 years or multiples of human generation). It is regulated by the need to balance our accounting books from generation to generation, writing down liabilities with new assets, i.e., creating wealth (capital). Gold is the judge and the executioner, the policeman, the yardstick, the de facto standard of value of all goods (and services).

It does not mean that one ounce of gold at the time of the Romans will buy the same amount of milk today. No. We have become more efficient in producing milk much more than gold. It takes less effort to produce milk, not gold. So ounce per ounce, blood, sweet and tears, like gold, remain as valuable through time, not cow milk. As much as each human being cares for his blood through space and time, he cares for his wealth which he measures in gold grain units, a standard that is universal and imposes itself independently of human will (consciously or not).

In times of crisis, people will "rediscover" the value of gold, no matter how deep it is buried in their subconscious. It is a mechanical process, an automatic reflex. The only thing the so-called gold bugs can do is clear the way for the natural phenomena to occur. They are the subconscious will of economic preservation of mankind. I hope that the current experiment with fiat money is the last and that we can recover sooner than later from the perilous deflation spiral we are in. My chilling guess, at this point, is that we will gradually sink into a new dark age of the 21st Century; the world will split into factions and wars, dividing itself akin the middle ages with kingdom like domains on a world scale before it coalesce again in the future (like plate tectonics). We are not going to go backward in time. We will not forget how to fly planes or use telecommunications, but huge empires and monopolies will break down into a divided market where specialties will prevail. Some parts of the world will be peaceful, others not. Social science will be the dominant subject of research and, finally, politicians and economist will catch up with mathematicians and physicist in the quality of their knowledge. In the end, this will lead us to a new era, the Renaissance of the future where in 200 hundred years, maybe, a future generation will become creative again in a diversified world where hopefully people of different backgrounds, religious believe and so on, will respect each other and learn from each others' experience. Diversity will replace integration; convergence will replace competition. Then and only then, gold will be the pillar of commerce and world trade, not inhibiting progress, but allowing it to develop at the same time as supporting the democratic right of people to be different as long as we don't step on each other, respectfully. Gold will be the uniting factor.

And that my friends, until we get into another cycle up and down, and the birds and the bees…

PJ Lafleur

June 2003


1   Carl Menger, Principles of Economics (1871) and Antal Fekete, Various essays (2003)

2   In the latest economic cycle, we have been hammered by theories about the supply side and lowering production cost and increasing productivity. Little has been said about the quality of life and being able to improve demand through this development. Wars and competitive pricing are supply side (destructive) tools of economic developments.

3   Gold occur naturally in a fashion that can be linked to human society. It is like a mini-us, a model of our social organization. The more we growth, with ups and downs, including crisis, so does gold accumulation (savings - capital) and circulation (money and trade), with the particular trait that it acts as a natural regulator, i.e., an insurance against abusive authorities and despotisms.

4   The natural logarithm function (base e) or log function base 10 is a mathematic function that help describe cumulative phenomena like population growth, capital growth and so on. The inverse is the power function, like in compound interest. Log scale is often used in financial graphs to discount the average growth of an index for example, to highlight the "real" anomalies or growth cycles, otherwise growth alone blinds the eye.


10 karat gold is 41.7% pure gold.