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Gold Market Update

March 29, 2001

Notwithstanding vast differences, gold, paper and credit have one common feature which is that virtually all the gold that has been produced and most of the paper instruments that have been issued are still outstanding. For paper this includes reprinting and refundings. There is a continuous bid and asked market for all the world's gold as well as for its paper money instruments. Their prices reflect the value that all the holders and potential holders place on all the gold and paper instruments outstanding.

The most salient differences between gold and paper credits is gold's scarcity and high cost of production. Paper money and credit can be produced on a continuum toward infinity and worthlessness. Therefore, for most of history government-issued paper notes had to be redeemable into gold to be acceptable (or sometimes silver).

Now, for the first time in recorded history, this generation is living in a world of totally fiat paper money. Even at today's low price, the dollar has lost 92% of its value against gold, mainly in the last thirty years. A consequence of this undisciplined system has been that the value of gold has been blurred, and its price during recurring periods of economic euphoria and despair has become the reciprocal of the value placed on stocks, bonds and currencies, and it matters not why that confidence does or does not exist.

Confidence is a form of credit. John Stuart Mill wrote 150 years ago: "Credit is something one has. It is not bestowed upon him, and once lost is difficult to regain."

During the 1920's, under a quasi gold standard, the Federal Reserve was revered as the institution that had conquered the business cycle. By 1933, the system was reviled. Its structure was altered and its power center was moved from New York to Washington. Then, in the 1970's the Fed was dubbed "the engine of inflation".

Consumer confidence has recently plunged but still remains high. The resilience of the Dow Jones, which has helped maintain the value of margin accounts, may be a factor. Confidence is also alive in the boardroom. A few examples: Two companies agreed to take $2.9 billion of AT&T stock instead of cash for Excite@home shares. Cisco will pour $l.5 billion into loss- and debt-ridden Softbank to gain Far East exposure. J.P. Morgan will put $5 billion of its own cash into a $13 billion new private equity fund. Then there is the speculation in power plants. Sell your own at a profit. Buy someone else's above cost and watch the utility rates go up. There are many more examples.

Then there are Alan Greenspan and others who maintain that the current slowdown is just an inventory correction, even though inventories, particularly for manufacturers' durables, continue to rise. This looks more like a capital goods correction with staying power. The slowdown has been touted as a New Economy phenomenon. One need only scan the Wall Street Journal to know that many Old Economy companies are suffering varying degrees of pain.

The U.S. financial position is precarious. One third of syndicated bank loans are reported to be junk quality. Furthermore, bank lines of credit now account for 30% of banks' commercial credit exposure. The recent Xerox example could be just a sample of the riskiness of this exposure in a prolonged recession. As the Deputy Governor of The Bank of England wrote recently: "Banks may not always be lenders of first resort, but they remain lenders of second resort. Central banks are still lenders of last resort." This may give comfort to borrowers, but perhaps not to holders of central bank-issued notes. Treasury secretary O'Neill may yet regret saying that he is not worried about the current account deficit, that a strong dollar is a side effect of a strong economy, and that financial crises were "great fodder for the media but they are not real hot for any one else."

Confidence often dies hard. In the spring of 1930, Walter Chrysler predicted that 1930 would be a record year for car sales. In the event, auto sales for the year were down a bone chilling 37%. As Rudyard Kipling said: "Words are the most powerful drug used by mankind."

The gold market may soon take heart from recent statements from those in the know. As a prelude to aggressive monetary expansion Japan's Finance Minister warned that government finances were on the verge of collapse. Alan Greenspan had previously testified: "One big risk is that consumer confidence could crumble like a dam being breached. The torrent carries with it most remnants of certainty and euphoria that built up in earlier periods."

If these gentlemen's fears are realized, the watchword for paper currencies may be: "Look out below!"

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