Gold - Harbinger of a Global Recession: At long last the fat lady sings
Originally published November 5th, 2007.
There is a well known expression, related to classical opera, which goes something like this: "It isn't over until the fat lady sings". This relates to the most famous arias sung by sopranos prior to them dying by various means, often suicidal, at the close of Italian operas. The analogy to the main theme of this short essay could hardly be more appropriate. In an economic sense, gold is taking the place of the fat lady and it is now her time to take centre stage having been relegated to the sidelines of our 25-year long opera called "FIATO", composed by the great American composer Sir, Dr, etc Alan Greenspan. People have been in love with Dr Greenspan's music for a generation. However, of late, since vacating his role as Chairman of the Fed Grand Opera House, the great composer has taken to blaming those who have developed convoluted and enigmatic variations on new financial instruments apparently beyond his comprehension. One has to beware of those harsh notes and tragic Italian endings!
Jokes aside, the recent 50 basis points interest rates cut by the Fed caught this writer's attention and brought him out of a 12-month self imposed silence. It is no doubt obvious to the reader that the US economy "lies between the devil and the deep blue sea". If the Fed had not cut interest rates the Real Estate market would have rapidly worsened, with the Sub Prime based mortgage sector leading the next tier of the mortgage market, the ARM's, comprising much of middle America, into an all out slump, with many high street banks horribly exposed. Given rapidly rising real inflation, represented by the core CPI variables such as food and gasoline, this would have caused a catastrophic collapse of consumer confidence and spending, causing in turn a major stockmarket crash. Add to this out of control overruns in the National, State and Public Sector budgets and the exploding costs of Education, Public Health, Pensions and the Iraq and Afghanistan Wars, and one has the recipe for a perfect financial disaster. The Fed accordingly bit its lip and did the only thing they could do given the awful scenario that confronted it, they dropped interest rates by a full 50 basis points to buy vital time for the colossal hedge funds to continue to unwind their dangerously exposed positions. However, one should be under no illusions that the inbuilt problems in the world credit - debt system have been resolved. Unsurprisingly, the markets took such an interest rate reduction, at this juncture, for what it really was and for what it means going forwards. It was a major signal for the markets to junk the US dollar in favour of other stronger currencies, gold, platinum, silver and other vital assets, and that is precisely what has happened and continues to happen.
To the key holders of US debt, and supporters of the US economy: China, Japan, Middle Eastern States, Taiwan and Korea, via their regular and massive purchases of US Treasury Bonds, this was an expected but nevertheless unwelcome development. Simply stated, it means that US debts to these countries have been and continue to be devalued away, with these economies being totally defrauded, as are US pensioners and savers whose life savings and pension funds are being destroyed.
The US has quite simply hitched the entire world economy to its economic and financial locomotive in the finest example of the "prisoner's dilemma game" in economic history; i.e. you have growth but eventually on our terms. No one dared break ranks in this high stakes economic game and ditch the global currency, the US Dollar. However, one should remember that no FIAT currency in history has ever stood the test of time. Most have never lasted even 50 years. The only real money is GOLD. This is because man, for all his ingenuity and vast and rapidly increasing store of knowledge, has not added one iota to his wisdom. Quite simply man, at the governmental level, is too venal a creature to be trusted with other people's money. The true gold standard, whilst rigorous and inflexible, kept Kings and politically elected leaders relatively honest. Even then, Kings and Princes hired alchemists in an attempt to transmute lead or other elements and substances into gold because they could never control their own finances, due either to profligate conspicuous consumption, orgies of grandiose construction of ever more tasteless palaces, or costly and often idiotic wars or creation of empires. Had they succeeded, the alchemists would have been the first architects of FIAT. However, the modern USA is the undisputed all time "King of FIAT". Now the Economic Piper has to be paid for the potentially "Hyperinflationary Genie" the US has visited upon the world.
Historically, the "fat lady" (GOLD) sings when inflation is headed into double figures and accelerates with the possibility of hyperinflation. In 1980, following the first major explosion of credit, post the end of the Bretton Woods Agreement, gold approached its "melting point" of US$ 850 per fine ounce, or, in today's CPI adjusted equivalent, US$ 2,700 per fine ounce. Paul Volcker, then Chairman of the Fed, fought the potentially dangerous situation for the US dollar by successively raising interest rates right up to 17% thus squeezing inflation out of the market, and, in the process, bringing gold back down to US$ 450 per fine ounce by 1986. However, under his successor Alan Greenspan, the money supply has been allowed to balloon to astronomic heights. One cannot but feel sorry for Mr Greenspan's successor, Dr Ben Bernanke, who faces a near hopeless and eventually very painful task. Since Paul Volcker's day in 1982, the world has witnessed the vast explosion in the use of increasingly complex debt based financial instruments. These arcane vehicles are based on the burgeoning financial science of risk management and diversification. They comprise mixes of collateralized mortgage based debt, bond and equity derivatives and various other instruments. However, the safety margin inherent in these instruments has become ever slimmer as their engineers, the banks, have chased increasing profits at the expense of greater risks. These comprise a web of complex derivatives held by a host of Hedge Funds. Very few people outside the banking world understand these financial instruments. The figures involved held in these Hedge Funds are staggering and beyond human imagination. By comparison, the GDP of the world's largest economy, the USA at 12 trillion dollars, is a relative minnow. The fact that major world governments have failed to regulate these instruments to protect society from the potential consequences will be debated by economists, financiers and regulators for many decades to come.
So, you may be asking, where is all this leading? The simple fact of the matter is that the Smart Money saw all this coming long ago and has been accumulating physical gold, platinum and to a far lesser extent silver, and Precious Metals stocks at bargain basement prices for the past five years. In the past two months the obvious has become apparent, the writing is on the wall for the US dollar and, eventually, the broader economy. Hence gold's recent breakout from the trading range US$630 to US$680. Gold's flight towards US$800 shows that the gold genie has at last escaped the bottle and the central bankers have thrown in the towel. With Bernanke's interest rate cut gold's rise will now become increasingly parabolic in a stupendous "blow off", which, as Newmont Mining Ltd's Pierre Lassonde said at Australia's "Diggers and Dealers" mining investment forum, "I know that it will have three zeros behind the first number, however, I do not know what the first number will be". This writer will not guess, but would be surprised if this number did not reach US$3,000 per fine ounce.
One thing is for sure, demand for physical metal will far outstrip supply by a factor of several times global production, as most significant gold mines require between 5 to 10 years from discovery of a good project to plant commissioning and production, dependent upon project size, location and a host of other important variables. Current world production is some several hundred tonnes behind global demand and has been so for several years. This situation will worsen rapidly from here on.
Finally, Ben Bernanke will have little choice other than to follow the same route as Paul Volcker to save the US dollar, as this is of paramount importance to the continuance of the USA as a global hyper power and the major influence in global development. To allow the US dollar to collapse and finally be rejected as the global unit of monetary exchange in favour of another currency would be unimaginable and unacceptable. Therefore, gold's great bull market will be the harbinger of a major global recession or, more probably, a depression brought on by a sequence of massive defensive interest rate rises required to support the dollar in its pre-eminent position as a global currency, with all the benefits, political and economic, that this brings to the USA.
In the meantime, if you haven't already done so, load up on quality gold and silver stocks and maybe some physical gold and silver as well while prices remain relatively low! The world to come looks at best volatile, uncertain and increasingly dangerous. If the USA decides to go to war, over the Iranian nuclear situation, this will only add fuel to the coming conflagration.