The Dollar Crisis and Coming Gold Boom

There are at least four economic and stock market crises that I’ve studied extensively that mirror today’s global economic conditions. Only many things today make today’s situation in many aspects much worse than the conditions that triggered past crises. That is why I say crisis is inevitable and great wealth will be destroyed in global stock markets. However, great wealth can also be built during this time as well. You don’t have to be a passive investor whose wealth will be destroyed. Here, I’ll examine just one of these crises - the 1997 Asian Financial Crisis and how the triggers for this crisis do not bode well for today’s situation.

The 1997 Asian Financial Crisis

Prior to 1997, the Asian “tigers”, in particular, South Korea, Thailand, and Indonesia attracted foreign investment in three manners: (1) The liberalization of investment policies and consequent elimination of restrictions on capital inflows; (2) the maintenance of high domestic interest rates to attract capital inflows; and (2) the pegging of domestic currencies to the U.S. dollar to allay fears of volatile currency movements.

Extremely high 8-12% GDP growth rates in South Korea, Thailand and Indonesia in the mid-1990s created rampant foreign speculation in real estate markets and created unsustainable inflated real estate prices. When the real estate bubble burst, a flight of capital ensued. As foreign currencies were withdrawn at record levels, the domestic currencies of the Asian tigers suffered great depreciation in their exchange rates against the Western denominated currencies of the investing nations. To provide stability to the economies of the Asian tigers, the IMF proposed a 3-pronged solution: (1) Cut back on government spending to reduce deficits; (2) Allow illiquid banks and financial institutions to fail, and (3) Aggressively raise interest rates to strengthen domestic currency.

Historically Comparable Scenario: 2000-2007 U.S Economic Timeline - Dot com crash, U.S. Federal Reserve manufactured real estate bull, Subprime mortgage fallout. Consequence: Real estate bear and depression??

The dot com bubble collapse caused the U.S. NASDAQ index to plummet from a peak of 5,038 in March, 2000 to 1,114 in October, 2002– a decline of 78% in less than three years. Runaway valuations and frenzied buying of a hot sector caused the tech market to collapse as investors and venture capitalists threw money at tech companies, inflating the value of companies that had never declared a single dollar in revenue or profit. Even though revenues, earnings and cash flow were all absent, this didn’t seem to make a difference as a rapidly rising index provided a rising tide that lifted all boats regardless of the missing components of quality or fundamental soundness.

When the unsustainable tech bubble burst, to ease the pain of losses in the stock market, the U.S. Federal Reserve cut the Fed Funds interest rates a dozen time from 6.5% to 1.25% (the discount rate was cut 13 times to 0.75%) and spurred massive speculation in the housing market. These massive interest rate cuts achieved two simultaneous goals: (1) They pulled the U.S. economy quickly out of a deep recessionary environment; and (2) Fueled massive equity gains in the housing and RE market that allowed many Americans to forget the pain they had just suffered in the stock markets.

However, those interest rate cuts directly created the sub-prime crisis that reared its ugly head in 2007. As buyers jumped into the U.S. real estate market to buy houses beyond their budget, courtesy of the Fed’s cheap dollar policy, rampant speculation in the real estate market created an unsustainable rise in real estate prices. In 2007, this lax fiscal policy came home to roost as a period of increasing interest rates caused defaults on low-quality, high-risk subprime mortgages. In turn, these defaults created a global liquidity crunch.

Interestingly enough, remember what the IMF’s solution for the Asian tigers was back in 1997 (a solution that worked by the way) ? (1) Cut back on government spending to reduce deficits; (2) Allow struggling illiquid banks and financial institutions to fail, and (3) Aggressively raise interest rates. When faced with the exact same scenario (caused by similar conditions), the U.S. Feds instead chose to (1) Raise the national debt ceiling and increase deficits; (2) Bail out insolvent banks and financial institutions by printing as much money as they needed; and (3) Aggressively reduce interest rates. Does anyone really believe that this solution will end well?

Strong and continued inflation of a currency will always invoke a couple of reactions:

1. Wealth will be stored not in domestic currencies but in non-monetary assets or in a relatively strong foreign currency to maintain Purchasing Power Parity (PPP).

2. Monetary and trade transactions occur in a foreign stable currency, not the domestic currency.

Certainly condition (1) has been executed by Americans, at least among savvy investors, for many years now with the accumulation of foreign currencies as well as the accumulation of lots of gold, silver and real estate in emerging and developing countries. Condition (2), while not yet common, is starting to appear. I’ve seen U.S. based merchants online now demand Euros as the default currency of payment rather than the dollar.

The examination of history above tells us that the only thing that can save the dollar right now is its replacement with a new currency, much like the German papiermark was replaced by the Rentenmark after the Reichsbank’s post-WWII hyperinflation monetary policy caused the utter collapse of the German mark. However, given that political deals struck between the U.S. government and OPEC back in 1973 ensured the dollar its role in international trade as the de facto international currency, replacing the dollar with an alternative American or North American currency, such as the proposed Amero, will be a monumentally difficult task. For now, the only conclusion I can draw from my brief examination of history is that unless a grand scheme is hatched to replace the U.S. dollar with another currency, great fortunes in gold and gold stocks are waiting on the horizon. Thus one should bunker down and get ready for the great gold boom.

Comments

[User 146128]

Double check your history. Every currency crisis since 1980 has been due to an overly restrictive U.S. monetary policy (a downswing in the world's largest economy has previously had a disproportionate impact on the export dependent countries).

In all of these events, the Fed forced the proxy for Real-GDP's rate of change to crash triggering a change in international trade flows.

The Bureau of Economic Analysis compiles Gross Domestic Product on a quarterly basis. But the operations at the "trading desk" have an immediate impact on the financial markets. Thus Real-GDP could be declining in both Sept & Oct overlapping the BEA's 3rd & 4th quarters in any year.

The combination of Sept & Oct's moves will be averaged, smoothed, or disguised by overlapping the BEA's 2 fixed reporting periods. This in turn masks the true extent and impact of the change in the proxy for Real-GDP.

So incontradistinction to Willaim Poole, there are currency moves that are predictable.

[User 142738]

Name one U.S. online retailer demanding the euro instead of the dollar as payment. I heard the pound sterling is declining too; are U.K. online retailers demanding euros instead of pounds, too?

Either you've found a merchant stupid enough to add a 2.5% overhead to accept a foreign currency, or you're lying outright.

[User 146128]

There will come a time ( unpredictable ) when it will be impossible for the government ( federal ) to collect enough in taxes to pay all of its expenses, including interest on the national debt. The Gov't can of course borrow an indefinite amount through the Fed. ( concealed greenbacking ) given a few changes in existing law. But that would lead to hyper inflation - i.e., a collapse in the credit of the Gov't. So the easy way, is the way the French did it in 1960. Simply say that beginning Jan 1 ( or any other date ), new dollars will be issued, and that each new dollar is worth 100 old dollars. Then follow that up with a largely state controlled economy.

In 1960, the French economist / mathmetician Jacques Rueff, during Charles de Gaulle's presidency, converted the old franc, to a nouveau franc, equal to 100 of the old franc. However, even with this substitution, inflation continued to erode the currency's value, though at lower rates of change, in comparison to other countries. And this new franc equaled 20 cents to a U.S. dollar. The old rate was 5.00 to a dollar.

In 1960, the French franc, which was one of the weakest currencies, overnight, became one of the strongest. Correcting policies included plans to 1) balance the budget, 2) stablize the currency, and 3) eliminate currency controls.

The gold content of the franc increased 100%, & 1) foreign exchange rates, and 2) France was on a managed paper standard; externally, on a modified gold bullion standard. With the new policies, France's economy strengthened, and the franc became fully convertible @ approximately its gold par, into gold for foreign exchange and into foreign currencies.

With the introduction of the euro, the franc in Jan. 1, 1999, was worth less than 1/8 of its Jan. 1, 1960 value

[User 146128]

Yes, gold's more attractive now than almost any previous time. Why? because the current account balance is destined to get wider, not smaller.

[User 146128]

Alfred Marshall, the Cambridge economists, is responsible for developing the cash-balances approach to money. For example, if individuals collectively desire expanding their cash balances (increasing the period over whose transactions purchasing power in the form of money is held), they will initiate a chain of events which will lead to a net reduction in their aggregate holdings of cash. That is, an over-all increase in the demand for money leads to falling prices, a decline in profit expectations, reduced borrowing from the banks -- and therefore a smaller volume of cash balances. Money thus is truly a paradox - by wanting more, the public ends up with less, and by wanting less, it ends up with more. All motives which induce the holding of a larger volume of money will tend to increase the demand for money - and reduce its velocity. Therefore, if there is a flight from the dollar, there will be hyperinflation in terms of dollar denominated assets.

[E.D. Hart]

Has anyone seen the price of palladium lately--no where near the highs of the past (aprox. $1000 if I recall) and a fall off in South African mining activity from the power shortages in that country. Wheres the Russian Palladium? Normally it comes to market this time of year, but the amount and timing is a state secret of the Russian Government. I'm a novice in the palladium market, but it seems logical to assume that perhaps, maybe, ever so possibly, palladium may be a better bet than gold right now as it is under major demand pressure upwards as platinum breaks out to new highs. Previously, if I can believe the news reports, platinum has been replaced by palladium at the margins for catalysts in the automotive, refining, and other industries. Any comments out there in SA reader-land who may have the inside scoop on the palladium market? I would love to hear your words wisdom from the palladium pros.

[J.S.]

Eric,

Palladium has had a nice run, however since last December, running up some 13%. However, it also just broke above last April highs of $390 recently. I'm no expert in Palladium but technically, yes, the charts for Palladium look promising. You may want to check out the technical chart for North American Palladium (AMEX:PAL) online. I'm in calls for this stock, and they just moved 100% higher last Friday. I'm hoping for 3-500% returns on the calls, but if you check out the stock chart, you'll see just as I described gold stocks lagging the underlying gold price above, PAL has definitely lagged behind the price of Palladium and may be the best way to play Palladium now as well as one of the safest. I know Stillwater is also another palladium/platinum company, but the price of this stock has already spiked like crazy on the news of platinum mines in S.A. temporarily shutting down.

[J.S.]

Eric, Did you get in calls on PAL, they are as of today up more than 750% now, and I believe up over 500% since my last posting on Feb 3rd. Not bad for a 14 day return. Hope you got in on the action, but I'd take my profits off the board now! -J.S.