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November 21, 2003

Fair Exchange or Daylight Robbery?
by Sean Corrigan

Complicating the evaluation of the timing of a turnaround is that deficit countries, both developed and emerging, borrow in international markets largely in dollars rather than in their domestic currency. The United States has been rare in its ability to finance its external deficit in a reserve currency. This ability has presumably enlarged the capability of the United States relative to most of our trading partners to incur foreign debt. -
Alan Greenspan, Cato Institute, November 20, 2003

Gold may not have enjoyed its brief peak above $400 an ounce for too long, but that was only because the Japanese central bank bought a cool $9 billion in the foreign exchange market, in one day, to try to prop up the sagging Greenback.

That intervention would take the total amount they have bought to around $80 billion since August - almost exactly $1 billion a day and enough to fund almost three quarters of America's yawning foreign trade gap over the same period.

But notice what is happening here.

American consumers take goods from their foreign suppliers and use them up. Those suppliers can find nothing that which they want in return from Americans, so they sell the surplus dollars, driving down their price.

The Japanese government then steps in and takes up those dollars simply by printing more Yen - effectively stealing from all of its citizens with existing Yen holdings by diluting the worth of the existing money, no less than a company which issues more stock undermines the value of the stakes of the existing shareholders.

The Japanese then buy US Treasury bonds with the money and so the US government can issue welfare cheques, pay bureaucrats to impeded progress, or secret servicemen to guard the Emperor, or to bribe friendly dictators, while resupplying its missile boats and bomber aircraft to threaten the unfriendly kind.

Some of those proceeds find their way into American banks where they are used to fund the loans to the American consumers (OVER consumers, in truth) who gave rose to the initial surplus of dollars offshore.

In all this goods are being consumed (and free markets and honest politics suborned) while more money is being created to record their destruction - in other words, inflation is being generated.

If you think this is a matter for indifference elsewhere - in the UK for example - ask yourself why your heating bills are rising, or why food prices may soon be going up. Ask why manufacturers are struggling with input prices which, in October, rose by their fastest rate so far this year.

True, many of the inflationary pressure building in Britain are the fault of Culpability Brown's vast expansion of the wholly ineffective public sector, and of the Bank of England's complicity in the orgy of debt-financed consumption and the housing bubble it has spawned.

But we all operate in an interconnected world and so, if Federal Reserve Chairman Alan Greenspan runs the US printing press to encourage reckless spending there - spending all the more exhaustive because it is thus in large part unearned by sufficient prior production - and if his Japanese counterpart Fukui, directed by Culpability's honourable equivalent, Finance Minister Sadakazu Tanigaki, helps pick up the tab by running the presses in Tokyo, this adds to the fact that they are thrumming - metaphorically - on Threadneedle Street, too.

So, yes, Gold did suffer a minor setback, dipping just under $392, as the nervous exited longs (and, possibly, as the even more nervous tentacles of the gold carry octopus tried to prevent a convincing break out). But does this mean the rally from 2001's nadir of $253 has run its course?

Highly unlikely, since the central banks can never costlessly create things, only claims on things - and claims of increasingly dubious worth at that!

Indeed, adding to the piquancy, Gold bugs will now be focused firmly on the fact that, on Wednesday, individual investors traded some 1,869 grams of gold bullion on the Chinese mainland for the first time since the communist takeover in 1949.

This raises the prospect that what China has done for the prices of coal, oil, grains and base metals, - as the most insistent marginal consumer of these, thanks to its role as America's primary mechanism for the transmission of inflation - it may now be about to do for the Sun metal, too.

Indeed, Bank of China, the only bank permitted to trade gold on the Shanghai Gold Exchange on behalf of individual investors, has 'deliberately set out to encourage participation.'

"The entry standard of 10 grams of gold, or equivalent to $120, is low and it will provide local residents another channel of renminbi investment," said the bank in a statement reported in the China Daily.

"It's good news for China's individual investors who have a unique passion for gold," said an unidentified industry insider, who has been in the business for nearly a decade. "The bank's new business has provided people a new investment alternative."

Now the Chinese save an enormous proportion of their income - in excess of 20%, compared to we Atlanticists with our paltry sub 3-4% ratios - and they have little choice presently but to put it in a bank they know to be saddled with lots of bad loans.

Moreover, their government keeps being upbraided by those ungrateful, protectionist Yanks, in yet another example of US official double standards, for doing exactly what the Japanese are tacitly encouraged to do - buying excess dollars with newly printed Yuan.

Additionally, they are frantically trying to cool the inflationary fever with which the importation of America's monetary excess has infected the domestic economy.

Thus they are casting about for things to spend these dollars on.

Given that a coterie of Chinese officials had just barely stepped off the boat, having signed $6bln in spurious equipment orders as tribute to keep Washington quiet on trade issues, before they were slapped with a regressive series of textile quotas - at the cost of an enormous loss of face, to boot - it would be no surprise if, in addition to pulling out of a series of agricultural purchases in response, the authorities in Beijing decided to dispense with their dollars a little more urgently and without sending the money Stateside in the process.

So it is just possible that this combination of private sector demand and public sector sanction will mean gold's next assault on $400 will not be too long delayed and that it might prove a little more durable on that occasion.

If it does, bear in mind that the same dynamics are at work around the world to make everything else people buy that bit more expensive also, even as Mr. Brown's demands on your income escalate further, or as Herr Eichel, Signore Tremonti, and Monsieur Mer in Europe stack up more unpayable IOUs - two-name Bills of No Exchange, accepted by Hegel and endorsed by the House of Keynes - and remember who it is you should blame when you find yourself increasingly out of pocket on a whole range of basic goods and services in the months ahead.

But, as ever, the basic laws of economics cannot be repealed, only suppressed, and the greater the degree of restraint and redirection imposed by governments on the course which the free market would take, ultimately the more damage the flood waters will wreak when, finally, they are unleashed.

As Greenspan himself conceded, in a footnote to the same speech excerpted above:

'Less than 10 percent of aggregate U.S. foreign liabilities are currently denominated in nondollar currencies. To have your currency chosen as a store of value is both a blessing and a curse. Presumably, the buildup of dollar holdings by foreigners has provided Americans with lower interest rates as a consequence. But, as Great Britain learned, the liquidation of sterling balances after World War II exerted severe pressure on its domestic economy.'

For once, we would concur.

Sean Corrigan
Capital Insight

Sean Corrigan is a principal of www.capital-insight.com, and a co-manager of  the Bermuda-based Edelweiss Fund.

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CAPITAL INSIGHT performs top-down analysis, wedded to an understanding of market action founded during long experience on the trading floor.

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