Gold and the truth about the US$

  1. 9,081 Posts.
    Golden rules still rule
    From WILLIAM REES-MOGG of The Times

    GOVERNMENTS lie. Bankers lie; even auditors sometimes lie. Gold tells the truth. In the mid-1960s, in New York, I met a very experienced old banker whose memories went back to the great German inflation of 1923.

    He told me to take notice of the rise in the free market price of gold, and said that he foresaw a major realignment between gold and the dollar. In fact, gold was near the beginning of a 20-year rise in price. The world's currencies were at the start of what turned out to be the great inflation of the 1970s.

    If one studies the history of the gold price, as the late Roy Jastram did in his book The Golden Constant, one becomes fascinated by the way in which the gold market sniffs out the truth. In the 1960s and 1970s, the gold price movement told one that the central banks of the world were losing the battle against inflation. In the 1970s they nearly lost control altogether, and inflation rose to 20 per cent or more, even in advanced economies.

    In 1980, the counter-attack, based on cruelly high interest rates, began to succeed. The gold price, after rising for 20 years, started its long fall, which also lasted for 20 years. In September 1999, as we can now see, the gold price reached a low point. Since then it has risen by 25 per cent to its present level of about $US320 an ounce. Three to six months later, between the end of December 1999 and March 2000, most of the world's stock markets reached their all-time peaks.

    It was already apparent in 1999 that world stock markets, with the important exception of some emerging markets, were offering very poor value. The dotcom bubble was still being expanded, but even apart from that, share prices were much too high. Feebler and feebler excuses were being invented to persuade investors that ever-higher prices lay just ahead. At the same time, gold itself looked cheap.

    Supposing an investor had then decided to clear out of United Kingdom equities and invest in gold. Such a person would now have a gold portfolio worth 125 per cent of its purchase price; the investor who stayed with equities would have a share portfolio worth 66 per cent of the price at which it could have been sold. In 2 1/2 years, the gold investment would virtually have doubled relative to equities.

    There are two ways of describing this movement of the gold price. One can say that gold has risen in terms of the dollar, but one can equally well say that the dollar has fallen in terms of gold. The dollar is the dominant world currency. Gold may be useful as a measure of dollar values, but it is the dollar values themselves which are huge.

    During US president Bill Clinton's second term, the US stock market soared in price. That drew in very large funds from the rest of the world. The US balance of payments went into an unsustainably large deficit. In the last three years of the Clinton Administration, the US deficit went from $US 100 billion a year, which could easily be financed by the US economy, to $US400 billion. It doubled every 18 months. The responsibility for this should be shared between the president, the US treasury, the Federal Reserve and the leading US investment banks. For three years, they operated a wholly reckless financial system whose main characteristics were a rising US stock market and a rising US deficit.

    Neither movement was sustainable and neither has been sustained. The US deficit still runs at around $US400 billion (about $700 billion), far too high for the health of the US dollar. US markets have fallen sharply, but could well fall further. Not surprisingly, this deficit financing of the stock market led to a corruption of institutions.

    In a disastrous way, dishonesty in the US administration - which wanted the boom to last out Clinton's term - weakness in the Fed, near-fraudulent fee-snatching on Wall Street, greed of already overpaid executives, and betrayal of sound principles by professional analysts, have damaged confidence in the US financial system.

    What damages trust in the US, damages the whole world.

    Investors were left wondering whom they could trust. Many honest businesses and banks have been damaged by this loss of reputation.

    The two-year bear market in the US has taught foreign investors that there is no easy money to be made by shipping funds by the supertanker-load to Wall Street and leaving them in the hands of these now partially discredited practitioners.

    This means that the US external deficit can no longer be financed by the in-flow of portfolio transactions. The dollar has fallen, a little against the pound, but more against the euro and the yen. When the US has a deficit of $US400 billion, the rest of the world must have a surplus of the same order and magnitude.

    The statistics are tricky, but that's broadly true. Other central banks are, therefore, still accumulating dollars, whether they want to or not. As Asia does most of the world's saving, the Asian Central Banks are the big accumulators; they are awash with dollars. Yet they must expect the dollar to continue to fall in value until the US economy ceases to run a huge deficit.

    Gold is an alternative investment to the dollar for these central banks.

    China and Taiwan have, in fact, been buying gold, despite the sales by other central banks. So have private investors in Japan and India. The orthodox central bank view is the world economy is near the end of a healthy correction, that growth is now recovering, that earnings will rise and normal investment patterns will reassert themselves.

    My view is more pessimistic. The late 1990s were an abnormal period in world finance. By any statistical measure of stock market prices - the price earnings ratios, the US deficit - the late Clinton years were a far bigger boom than that of the late 1920s. No doubt the global economy is now much stronger than it was then, but the scale of the Clinton distortion is a measure of the likely scale of the correction that has to follow. Neither stock markets, nor the prospect for earnings, nor house prices in the US or UK, nor the US deficit suggest to me that the global correction has been completed.

    The price rise in gold is telling us the truth, not about gold, but about the US dollar. The US external deficit has to be reduced. That means the dollar has to fall further. There is no early prospect of a return to confidence in the US stock markets. There is no point in the US raising interest rates, which would weaken the US economy and only postpone the necessary realignment of dollar exchange rates.

    Gold will continue to out-perform stock markets, as it has for the past two years. Pension funds are going to be in serious difficulties.

    All of this does not look like a short-term adjustment. We may find the decline of the dollar is the most important global movement of the decade.

    The Times

    The Australian

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