Man The Lifeboats

A Letter to Bill Murphy, Le Patron @ Le Metropole Cafe

by Jim Puplava | April 28, 2004

Dear Bill,

Last year investors purchased a record amount of gold. Preliminary estimates for 2003 indicate that investors purchased 33.9 million ounces of gold. That is the largest amount of gold purchased since 1967. The year 1967 was a pivotal year for the gold markets. Investors bought so much gold that they forced central banks around the globe to close the private sector gold window, which allowed private investors to exchange their currencies for gold. This eventually was the beginning of the end of the Bretton Woods dollar-gold standard. It also gave birth to the modern day gold market.

Here we are today almost 37 years later and we are witnessing the beginning of the end of the free-floating dollar exchange standard. Like the earlier London Gold Pool, central bankers are trying to forestall the inevitable. Inflation is rampant everywhere as evidenced by the rise in commodities. Central bankers have printed enough money and have injected enough credit into the system that inflation has finally spilled over onto Main Street. Inflation has manifested itself throughout the financial markets in the 90's as reflected in the stock market bubble of that era. More recently it can be seen in asset bubbles in the stock and bond markets, mortgage markets, real estate, and in consumption by debt-laden American consumers. Even now inflation is visible in doctored inflation indexes such as the CPI and PPI, which are now running at annual rates of 6-7% a year. The current federal funds rate of 1% stands in sharp contrast to economic growth rates of 4-5% and inflation rates of 6-7%. Investors are now receiving negative after-tax returns on their money by investing in cash, bonds, and in stocks.

Now investors must prepare for the inevitable unraveling of the current free-floating dollar standard. The beginning stages of its unraveling are now in place. The twin U.S. deficits in trade and at the governmental level are untenable. This year’s government budget deficit will amount to $740 billion! That's a number you will not hear anywhere. On Wall Street they only talk about a $521 billion number. This number excludes $200 billion in planned borrowings from Social Security and other government trust funds. In the next four years the government will borrow $1.5 trillion of Social Security just to keep deficit levels at respectable minimums--whatever that may mean. We are heading for $1 trillion a year deficits into perpetuity and we haven't even begun to face the Social Security and Medicare crunch that accelerates after 2008 when the first batch of boomers enter the retirement market.

On the other side of the ledger, concerning our mammoth trade and current account deficits, there doesn't appear to be any sign that the dollar's fall has corrected these imbalances. Much of the U.S. trade deficit is structural from energy to capital goods since very little is manufactured here anymore. In fact, the U.S. will have to compete and import more of its energy needs as production continues to fall in this country. It is one of many reasons why we have two aircraft carrier battle groups in the Middle East and have over 100,000 troops deployed in Iraq. It will take more than a 50% decline in the dollar from here before we make any significant improvement in remedying our current trade imbalance.

The picture doesn't get any better if you look overseas. Europe may not have the same debt levels as the U.S., but their moribund economies are dependent on exports to the U.S. and Asia. Japan's economy is improving, but its economy is totally dependent on exports to China and the U.S. They must intervene constantly in the currency markets in order to protect and keep their trade advantages. The net result of Japan and China's intervention is that foreign central banks now own close to $1 trillion or almost one quarter of all U.S. publicly held debt.

In May the European Union will expand by adding 10 new member states. Even as the Union expands, many of its members from France and Germany to Italy are having trouble keeping their budget deficits in line with EU requirements. Just about every nation is having difficulties -- difficulties that will get more troublesome, if the U.S. economy implodes. Europe and Asia are dependent on exports and if those exports collapse with a downturn in the U.S. economy, then those nations will inflate as well. The social demands by its population wouldn't tolerate a reduction in social welfare benefits. So governments will have no choice but to inflate and devalue their currencies.

The point of all of this is that central banks and governments around the globe have embarked on a massive reflation and a competitive currency devaluation effort that harkens back to the 1930s. The world’s economies are heading for trouble. The financial markets have entered into a period of extreme danger as the Fed readies the markets for a series of rate hikes that end in disaster. The last time the Fed reversed course in 1999 the NASDAQ and stock markets crumbled and the U.S. economy quickly headed into a recession. This was nothing to the derivative mishaps and currency crisis of 1994, the last time the Fed seriously pursued a serious rate tightening.

Since then, leverage in the financial markets has increased nearly tenfold. Derivatives at U.S. money center banks have gone from $16 trillion to over $64 trillion. The carry trade is much larger and major companies, such as GE, GM and Ford, are engaged in large interest rate swaps. Fannie and Freddie have ballooned their balance sheets and companies and consumers are up to their eyeballs in debt. The Fed will take its time raising rates and when they do, rate hikes will be minimal. If the Fed over tightens, the stock, bond and real estate bubbles will implode ending the recovery and the current bear market rally.

Picture in your mind a stormy sea with everybody leaning on one side of the boat. Water is rushing on board from the weight of all of the passengers. The passengers need to get over to the other side of the boat, but if they do so in unison, the boat capsizes. The boat captain (Mr. Greenspan) hopes that the passengers can gradually get over to the other side without capsizing the boat. That is why the Fed is taking its time giving the markets or large speculators plenty of advance notice, hoping things go smoothly. Otherwise, a sudden move by the passengers leads to mayhem and the capsizing of the boat. The barometer is dropping rapidly, so it remains to be seen if there can be an orderly move to the other side of the boat. History shows that this is highly unlikely.

Let me use another analogy from the recent movie, Titanic. The lookout on the Titanic has just discovered that a large iceberg field lies ahead and a collision is inevitable. He alerts the captain. The problem is there aren't enough lifeboats (gold and silver). First class passengers are a priority (financial elites). Passengers in steerage are too numerous, so they must be kept calm and fooled. Only after the elites are safely aboard the lifeboats (gold and silver), will those in steerage be told of their fateful predicament.

This is where we are today.

The lifeboats are gold and silver. The number of boats available are few and certainly there are not enough to go around for all of the passengers. The captain and the ship’s crew must keep the passengers in steerage mollified until they are safely aboard. So they tell everyone that things are okay. The last thing they want is for the vast majority of passengers to head for the lifeboats. This is what is going on in the gold and silver markets today. The sell off and panic in the markets are the financial elites' attempt to get those in steerage off the boats, so that the elites may safely get on board. A major currency storm is headed for the financial markets and the only safe haven will be real money.

Imagine a similar situation that developed in Argentina over the last few years. Those investors, who owned gold, silver, or had their money in stronger currencies, survived the storm. Those who had their money in cash with the banks or in government bonds or stocks lost almost everything. This may be what is about to happen over the next two months. There is wide scale intervention in the financial markets. The U.S. dollar and the U.S. Treasury markets are being held up by massive intervention by the Bank of Japan and China. There is evidence that intervention in our stock market is taking place. We also know that there is widespread intervention taking place in the silver and gold markets.

So where does that leave us?

Given all of the turmoil that is coming to the financial markets, do you want paper lifeboats or something that is more secure and solid such as gold and silver? Look at what you are paying for groceries, gasoline, utilities, services and everything that you need to live. Then look at what is happening to the price of things that you don't need: DVD players, Flat screen TV’s, cars, clothing and other luxury goods. Draw your own conclusions as to which type of investment you would rather be in -- paper or something tangible that isn’t someone else's liability.

These are the times that separate the men from the boys as well as the speculators from investors. As for myself, I was a big buyer today. It isn't hard when you see the barometer dropping rapidly. If interventionists want to panic the markets and drive the price of gold and silver down, then I will gladly take it off their hands. I prefer a lifeboat made out of something solid versus one made out of paper that will sink.

Respectfully,

JP
www.financialsense.com

© 2004 James J. Puplava