WHY GOLD IS SET TO SOAR
by John Myers
"Many of today's investors were still in diapers during the great stagflation of the 1970s. Those who weren't will never forget the darkest period in modern financial market history."
Stephen Roach,
Morgan Stanley Dean Witter
A decade ago I was 14,000-feet deep in a South African gold mine, sweating bullets and reaching for a bottle of water. My tour guide, a hardened South African mine executive, seemed immune to the heat.
"Mr. Myers. Mr. Myers!" I could barely hear him above the buzz of the rock drills only a dozen feet away. "You must understand," he yelled into my cupped ear, "the price of gold always comes down to one thing and one thing only. The number of U.S. dollars out there."
I don't know where he is today, but I bet he has a smile on his face. Why? Because he understands that the world is experiencing the same kind of dollar inflation today that made South Africa rich a generation ago.
Right now the United States is fighting a two-front war - one against terrorism and the other against recession. George W. Bush understands that the economy condemned his father to be a one-term president.
That explains why Washington is doing everything it can to inject money back into the economy and why the Fed frantically cut rates last year. On Jan. 3, 2001, when the Fed cut its key federal funds rate by half a percentage point to 6%, it was because of a slowing economy. The move was the first of 11 cuts in 2001, which slashed the key rate by 4.75 percentage points to 1.75%.
But Washington realizes this isn't enough. So it is reverting to its old ways, specifically a new round of spending. The budget surplus of 1998-2001 has evaporated. Still Congress is eager to implement the kind of spending that would make economist John Maynard Keynes proud. Congress will inject over $200 billion into the economy this year, and unless the economy begins to turn around soon, that total will grow. Washington has one final trick up its sleeve - running the printing presses day and night. Of course cash is not really created, or at least not much of it. Instead the Treasury controls the amount of currency by creating more money through loans to banks, which in turn lend it out to businesses and individuals, expecting them to jump on the low interest rate bandwagon.
The adjusted monetary base - also called super money because banks loan it out in multiples - is growing at a double-digit annual rate. In fact, in October 2001 it grew from $614 to $637 billion, one of the largest single-month climbs in memory. Moreover the adjusted monetary base measured just $500 billion in 1998. The addition of $137 billion in just over three years is remarkable.
Zero maturity money stock (MZM) has risen by $500 million, or more than 11%, over the past year. The broad-based measure of money, M3, has risen by more than 10%. And over the past year $20 billion in new cash has been pumped into the system. There is now $540 billion in cash in circulation, double the outstanding cash of 1990.
In an ideal world the amount of money would grow lockstep with the economy. But the situation we have here is one where money is growing at a rate five to 10 times faster than GDP. Basic economics tells us that if the money supply is growing faster than the amount of goods and services, we end up with inflation. It is a simple case of too much money chasing too few goods.
If, and this is a huge "if," consumer confidence continues the gains it showed in December, along with the low interest rates available to borrowers, there is a strong likelihood this excess money that has been made available to the banking system will enter the economy. With the shallow growth ahead for this year, expect a greater increase in money than in productivity.
There is a final component to the inflationary argument: the United States is on a war footing. Congress could easily add $200 billion a year in military spending. That would increase defense spending by one-third, from 3% of GDP to 5%. Already supplemental appropriations have raised the original fiscal year 2002 spending level by $47 billion to $363 billion. This would be a reversal of the 1990s when defense spending as a share of GDP dropped from 5.5% around the time of the Persian Gulf War to the inadequate 3% last year.
One of the major reasons inflation has been subdued for the past decade has been the decline in military spending. During the Cold War in the 1960s, the U.S. military budget absorbed about 9% of GDP. In the aftermath of Vietnam, defense slipped to less than 5% of the economy. President Ronald Reagan's final assault on Soviet communism temporarily increased the defense allotment to nearly 6.5% of national income, but it has been in decline ever since. Looking at the big picture, consider that national defense spending as a share of total federal budget outlays has plunged from 50% in the early 1960s to 15% more recently.
The problem with military spending is that it is not nearly as productive as non-defense spending. One hundred billion dollars spent building tanks does not add to the productivity of the nation the way $100 billion spent on a new dam project or tax cut would. "The military ratchet was the most important single influence in raising prices and reducing the value of money in the past 1,000 years," writes Glyn Davies in his book, A History of Money.
No one would argue that the guns and butter legislation passed by President Johnson during the 1960s had a major part in stirring the inflationary kettle. Of course, the real impact of that legislation took a few years to assert itself.
What experienced investors realize is that there is a time lag between the creation of money and the onset of inflation. Remember that the Treasury makes money available to the banks. Sometimes that alone is enough. Economists call it pushing on a string. But invariably there is a tug at the other end of that string by borrowers.
In the '70s TV show "Barney Miller," a suspect is brought into the precinct after his wife reported a robbery. It turns out the robber was her husband. He confesses to his wife and Captain Miller that he liquidated everything he could and used the money to buy more gold.
She looks at him with tired eyes. "Maybe you're wrong, Harvey. Maybe we won't get war, famine and runaway inflation."
"Stop being such a damn pessimist!" he yells.
A few gold bulls are beginning to think the gold pessimists may finally be wrong. The 1970s were a spectacular time for hard asset investors. This decade could be even better. The reason - the continual decline in the world's raw resources. Just as big oil is spending less at the drill bit than it is with acquisitions, so too are mineral companies spending less on exploration.
The Metals Economics Group reports that total worldwide nonferrous exploration stood at $5.2 billion in 1997. However, mineral exploration expenditures fell 29% in 1998, 24% in 1999 and 7% in 2000 (final numbers are still pending for 2001). As a result exploration expenditure last year were $2.6 billion, 50% of what they were only three years prior.
It is not hard to see that as current exploration slows down, we could be headed for a supply squeeze on several fronts.
According to a recent report by Global Resource Investments, "Mining is a depleting business and in real life mineral deposits are depleted fairly rapidly while at the same time, discovering new mineral deposits happens only occasionally."
Take copper as an example. The world consumes 16.5 million tonnes each year. However, the biggest copper mines in the world hold 12 to 16 million tonnes of copper. That means that each year the world consumes a major copper mine. And replacing these mines is becoming a tougher proposition. While the world still has considerable reserves, much of it is either of poor quality or in politically unstable parts of the world.
Yet buying up existing copper mines adds nothing to the world's copper supplies. At some point this fact will result in shortages. This, combined with inflation, will push hard asset prices into the stratosphere.
One of the biggest winners, I believe, will be gold.
John Myers,
for The Daily Reckoning
dailyreckoning.com |
