Be Careful for What You Wish
Dr Richard Appel
November 5, 2004
Many investors and traders that have a keen desire for higher gold complex prices, believe that it will be wonderful when gold finally breaks free from the shackles that have long restrained it, and soars wildly higher in price. Some of these individuals believe that gold is headed towards $600 while others can barely contain their emotions believing that the sky's the limit. Many of these excited souls ponder the extent of their future wealth when the noble metal ultimately surpasses its earlier $875 high set in 1980, and soars to the $2,000, $3,000 or even $4,000 level that certain conditions may ultimately justify. Unfortunately, few direct their thoughts to even remotely consider the events that must first unfold in order to propel gold to these mind-boggling prices. Further, far fewer have any understanding of the consequences to our great nation and its citizenry, themselves included, that will result if these underlying driving forces truly play out, and propel the eternal metal to the untold heights that they believe are its fate.
I feel that the majority of gold community members who believe that the yellow metal is destined to greatly rise, ascribe to the belief that the dollar will sharply fall in parity against the currencies of our international trading partners. They rightly recognize that our current account, balance of payments, and fiscal deficits cannot be sustained, and will one day prove damaging to our nation. They give lip service to the recognition that at some point other countries will demand a real form of payment, in return for the valuable goods and services purchased by our country, rather than continue to solely accept declining dollar credits. Yet, they avoid believing what they see when they gaze into the future.
It has been incredibly beneficial for America to possess the world's reserve currency. Our officials learned long ago how to use this condition to their advantage. It provided our Federal Reserve with the ability to literally create dollars at will, without the need for our inhabitants to be similarly productive as did all of those who supplied us with their wares. Heretofore, controlling the reserve currency came with the responsibility to maintain its integrity and value. This was the case for decades because it benefited international trade and fostered both a strong American economy and financial system.
Unfortunately, for various reasons this goal has been abandoned. At the forefront of these, is that possessing the world's primary currency allowed our country to become supported by the sweat and efforts of those toiling in far away lands, without our giving them anything of value in return. All that was necessary was to create dollar credits literally from thin air, and use them to pay for our foreign purchases. Sadly, this state has caused America to become accustomed to living far beyond its means. This, without the knowledge, recognition or understanding of this true underlying reason by most of our fellow citizens.
The enormous and increasing U.S. budget deficits on the other hand are similarly unsustainable. To date, countries such as Japan and China along with the European Union members have helped fund these deficits. They acquired Treasuries with the expectation that the dollar would maintain its value, and gladly purchased our bills, notes and bonds with the belief that they made a wise investment. History taught them that when they desired to sell these assets they would not only receive a similar or greater amount of their own currency in return, but would also gain interest on their holdings in the interim to boot. They were in for a shock.
I believe that gold is presently quite undervalued. To my mind the purchasing power of an ounce of gold is far greater than the current $425 for which it sells. However, in order for gold to trade far in excess of the $600 or so that I feel conditions currently warrant, a number of events must first transpire.
The United States has been riding the crest of a growing tidal wave since 1971. This began when President Richard M. Nixon "closed the gold window." That infamous day occurred in August when I was first honeymooning in Europe. During the ensuing week or so after the announcement I could not exchange more than a $20 bill or traveler's check for any local currency. It was that fateful announcement that removed the final vestige of gold backing from the dollar. This opened the door to an unconstrained issuance of paper money, and later electronic dollar credits, by our Federal Reserve System.
Throughout the subsequent period our country became increasingly dependent upon the rest of the world's generosity, or some say naivete. Initially, they bought our Treasury paper with the expatriated dollars that flowed from our land in exchange for their products. This helped fill the gap and largely paid for our government's chronic fiscal deficits. Later, our ever kind trading allies gladly accepted our readily produced dollars in exchange for their valuable services and goods. They were thrilled when the dollar soared in value on international markets between 1995 and 2001, and barely batted an eye when the greenback reversed course and began its present descending path.
We have all heard the euphemism that, "the U.S. pretended to pay foreigners with dollars and they pretended to be paid." In truth, it became a symbiotic relationship. The U.S. government found a way to finance their growing deficit spending propensity, and our trading partners required an eager outlet to sell their goods and services. This in turn helped improve their economies, their employment rates and the standard of living for their citizens. It also helped keep their leaders in power.
The result was an unprecedented explosion in both global economic growth and the creation of U.S. dollar credits. Unfortunately, just as it appears that we are in the twilight of the world's greatest, widespread economic boom, we are also at the dawn of what will likely become the demise of the heretofore almighty dollar.
At some point, one by one, our trading partners will balk at being reimbursed with dollars for delivering their goods onto U.S. soil. The likely trigger for such an event will be the declining parity of the dollar. The question is the level of pain that each country can withstand, i.e. the extent to which the dollar must fall against their local monetary units, before they rebel.
What few people recognize or care to consider are the events that will unfold when this time arrives. True, gold will be at a far higher dollar price. But what economic and social price will be its cost?
When the world begins to reject the dollar they will sell their accumulated U.S. Treasuries. They will no longer desire these vehicles to act as a store for their dollar holdings. This will cause a sharp increase in domestic interest rates as their Treasury paper is sold into the market. Our earlier loyal trading partners will then take their received dollars and sell them for their own currencies. This will act to further depress the dollar's value on the world market. Further the Federal Reserve, who will be the ultimate redeemer of the Treasuries, will be forced to issue new dollar credits. This will create a flood of dollars entering our monetary system, will balloon our money supply, and threaten a serious outbreak of domestic inflation.
The combination of increasing interest rates, a falling dollar, and a sharply rising money supply will produce a second series of events. The higher rates will damage the balance sheets of our country's businesses and will threaten the housing market. Further, the monthly interest payments on our already highly debt burdened populace will soar. Stocks will weaken and single family home sales will decline. This will drive consumers to limit their purchases.
These damaging events will be amplified when the "wealth effect" begins to wear off and Americans experience a triple whammy. Stocks will plummet, homes values will fall, and the news of layoffs will fill the airwaves. This will act to further restrict consumer spending and will foster a sharp decline in business activity.
Additionally, the falling dollar will increase the price of imported goods entering our markets. This, combined with the sharply rising money supply, will not only add to the cost of living but will promote the threat of inflation. Further, foreigners will reduce their U.S. stockholdings for fear of additional currency and stock market losses.
Consumers, already reeling from their increased cost of living, the fear of additional stock and home equity losses, and the threat of reduced incomes or their own unemployment, will further retard their spending. This will add to the damage sustained by our fragile economy and place still more workers on the unemployment rolls. These will swell while personal and business bankruptcies soar, and the cycle will feed upon itself and spiral lower.
Of course the Federal Reserve will attempt to counteract these forces. We have already been comforted by statements from Alan Greenspan and Ben Bernanke, a Fed governor, that they will create dollars at will if needed through various schemes to circumvent a catastrophe. However, if they execute their methods they will only worsen the outcome. Yes, the Fed's machinations will likely temporarily forestall a severe economic downdraft and may indeed avoid a derivative meltdown, but at what cost. If they aggressively act in this fashion their deeds will only further damage the integrity and value of the dollar, drive gold far higher in price, and likely precipitate a damaging inflationary event. In fact, we may be forced to endure the worst of all worlds where our domestic prices are soaring while business is stagnating or collapsing.
I have not painted a pretty picture of the potential outcome when the world ultimately refuses to accept the dollar. I have done this with the desire to warn readers to protect themselves. "Forewarned is forearmed." I would highly recommend that you greatly reduce all forms of debt. Further, I believe that you should not only increase the percentage of your gold and gold share holdings but Americans should also add to their cash positions and hold them in the form of short-term U.S. Treasuries. I hope that our leaders have prepared for such an event and are successful in the execution of their contingency plans. However, for those who will continue to anticipate a joyous and happy ending to soaring gold and gold equity prices remember, be careful for what you wish.
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