While most nations of the world are issuing debt, a few nations have taken the dramatic step of issuing debt and printing money. Most notable is that of the U.S., which is allowing the Federal Reserve to purchase Treasury bonds as well as toxic mortgages. The purchase of treasuries by the Fed is equivalent to a consumer taking out a cash advance on a credit card, which, for both parties, simple isn't sustainable. Throughout the history of man, the method that the U.S. is taking to get itself out of hock has never worked successfully over the long haul.
Civilizations reach their zenith when consumption becomes so insatiable that it leads to a debt too large of a burden for its population to handle, thus, allowing another nation, usually the largest creditor, to take over their throne. But before that occurs, undoubtedly, that civilization continues to devour itself in a swell of insurmountable debt, a victim of its pride, before disintegrating into a sliver of its former self, never to return.
The fall of Rome in 476 AD, Spanish Empire in the 1800s, the British Empire in the 1900s, and the Weimar Republic of Germany after World War I, to name a few, all have similarities in their demise—over-expansion through war, leading to a voracious, unsustainable need for debt, which, ultimately, bankrupted them.
As stated in my May 31, 2009 article “Seek Refuge in Modern Day Communism,” this is also the case of the U.S., whose debt is owned 45% by China and Japan and whose currency foundation and world reserve status is starting to come under increasing scrutiny by nations such as China, India and Russia. As documented in previous articles, China is starting to navigate around the dollar with its trading partners by opting to underwrite contracts in each other’s currencies rather than the customary U.S. dollar. China, especially, has taken steps to ensure its security by purchasing hard assets in increasing amounts, such as mines, farming rights and precious metals such as gold, rather than continuing to limit its investments to only U.S. treasuries.
U.S. citizens are also very aware of their country’s increasing debt obligations, made known through recent polling, which states that 19% of all U.S. citizens believe that the number one concern of the federal government should be containing the deficit and government spending, compared to 31% for job creation and economic growth and 16% health care. As the federal government tosses around the idea of health care reform, currently slated to cost more than $1 trillion, a cap and trade bill that is widely considered to be the largest tax bill in U.S. history and protectionist, and increasing deliberation over whether the Congress should issue a second stimulus bill, this concern is only likely to increase even more so with time.
In the aforementioned article, "Seek Refuge in Modern Day Communism," I stated that the total U.S. debt is slated to reach 100% of GDP by the year 2013 based on slightly less generous information provided by the Obama administration in their 2009 budget, which they are undoubtedly lowering as I write this article. This figure does not include the unfunded obligations of the federal government to Social Security and Medicare, which is currently equivalent to several times the current U.S. GDP.
Increasingly aware of the depth of the U.S.’s debt issue, investors large and small are stockpiling precious metals such as gold and silver, which traditionally has been the place to be in inflationary times. It is obvious to many that inflationary times are ahead for the U.S. for some time to come; however, that time is not going to be now nor probably even next year.
“But the government is printing money like mad,” you say.
“That, by definition, is inflation.”
You are correct.
“So why are we not going to have inflation soon?” you retort.
Very simply, there needs to be demand for goods in order for inflation to take hold. Without it, prices will typically remain relatively stable or potentially fall. Personally, I believe that we are still in a deflationary spiral and will remain there for the foreseeable future. I believe this for several reasons-- some of which I stated in my article “Profit From Other's ‘Green Shoots’”-- which are highlighted (with revised information) below.
- The U.S. government is coming under pressure from world leaders such as Angela Merkel to stop stimulating its economy, and, recently, even Ben Bernanke has started to add pressure to the government to curb its record spending.
According to the latest Bureau of Labor Statistics information, the official unemployment rate in the United States reached 9.5% in June, a 1% increase from May (9.4%). However, the increase in the unemployment rate has averaged 4.3% month-over-month in 2009. Most economists who see "green shoots," however, point to the decrease in month-over-month seasonally-adjusted payroll figures and remind us that unemployment is a lagging indicator as to the prognosis of the economy.
However, a figure that is often excluded when unemployment is discussed is the percentage of people unemployed, underemployed, and marginally attached, which gives economists a much more accurate picture of unemployment statistics. According to the Bureau of Labor Statistics (BLS) that rate stands at 16.5% as of June and although the growth appears to be slowing in recent months, it is important to note that by the BLS's own admission the underemployed rate is very difficult to calculate. In fact, the unemployment figure, which is the media's traditional headline number, is only based on those persons who have actively looked for a job during the past four weeks.
Robert Schiller's web site Irrational Exuberance, Second Edition, states that real home values have fallen more than 55% since 2006 and are still more than 20% higher than the historical median, based on real home price data from 1890 onward. This chart compiled by The New York Times' Bill Marsh shows just how exuberant the housing market was at its height when compared to historical prices.
According to the MIT Center for Real Estate, the Moodys/Real Commercial Property Price Index (CPPI) is approximately 50% higher than its base point of January 2001. While the historical data points in the index are limited, it is conclusive that the real estate market started to increase exponentially around the start of this period. In fact, based on Case-Schiller information, the boom in real estate started in or around 1997, so, in fact, the CPPI base figure may be drastically overstated as a historical starting point, meaning that the CPPI index might have even more room to fall from its current level. This means that the commercial real estate bubble is only just starting to pop.
Research from the St. Louis Federal Reserve states that the U.S. historical median personal savings rate from January 1, 1959 until May 2009 has been 6.8%. If you exclude the data from January 2005 onward, since savings during this period until mid-2008 ranged from -2.7% to around 1%, the historical personal savings rate stands at 8%. As of May 2009, the personal savings rate was 6.9%, a 23% increase from April.
In my opinion, I believe that due to deteriorating employment conditions, households will hoard their hard earned money and the savings rate will exceed the historical rate by probably 3-4%, to a rate of 10% or more.
Consumer spending accounts for approximately 70% of the current United States GDP.
These concerns, along with others listed in the aforementioned article, remain strong and are all correlated. Looking at each objectively, it is nearly impossible to see where domestic demand would originate from, unless, of course, if the government were to step in with a new stimulus package. If that is to be the case, however, then it is likely that the markets would have fallen precipitously by that point and, to date, the S&P 500 is up 10% for the year as of Friday's (7/24) close.
You could argue that global demand remains strong, especially for commodities, based on weekly articles, which state that China is eying yet another foreign commodity company to take over, or perhaps one could argue that a strong Euro provides Western Europe with enough purchasing power to buy cheap goods from exporting nations like China. However, you would be overlooking a few key points.
- China’s $585 billion stimulus package earlier this year was much larger than that of the U.S.’s as a percentage of GDP-- 13% vs. 5%, respectively. According to a Wall Street Journal article, China’s debt as a percentage of GDP now stands at close to 35% and its relatively new corporate bond market has issued nearly $15 billion so far this year, compared to only $10 billion for all of last year. With Chinese debt exploding this year, one is led to believe that China, a traditional fiscally conservative nation, does not want to tread down the same path as most Western nations.
According to another Wall Street Journal article, China plans on spending approximately 38% of its stimulus bill on major infrastructure, such as railroads, highways, airports, etc., with 25% going toward rebuilding areas affected by last year’s Sichuan earthquake, 10% going toward low-cost housing, 9% toward rural development, 9% toward industry and technology, 5% toward the environment, and only 4% toward health care, education and culture. In many ways, China’s stimulus package is much more effective and determined to build growth than the U.S. package, which is chock-full of earmarks and places little importance on infrastructure, energy independence, education, or small business.
However, a point, which is often overlooked is that China’s per capita income is just $3,300, ranking it 110th in the world and its savings rate is traditionally between 30-40%. Building a superior infrastructure network is a fantastic use of capital; however, if the ability to use it is not yet there, then it is only an excellent plan for the future, which is precisely what it is in China’s current case.
In order to jump-start consumer spending, China is subsidizing consumer spending for autos and home appliances and allowing cheaper credit, although still stringent by U.S. standards, for perspective home owners. The soon-to-be superpower is facing a huge spending conundrum with relation to its populace, since the two ways to grow GDP are through exporting, in which it currently ranks second to Germany, or consumer spending, which is not ingrained in its culture. China also does not want to use the U.S. and other developed nations as role models for its citizens, as debt consumption has suffocated many Western economies, yet that will be difficult to control based on all of the Western influences that have been penetrating the communist nation for decades.
Western Europe, which has had its troubles with unemployment in the past-- largely, some would argue, due to it being socially progressive-- has also stimulated its economy. However, unlike the U.S., its leaders are attempting to rein in spending. In fact, Angela Merkel, Germany's Prime Minister, has specifically stated her displeasure in the U.S.'s policy several times during the past few months. With the Euro having appreciated recently, you would think that Europe's economy is headed in the right direction. However, you would be sorely mistaken.
For instance, Europe's largest financial country, Germany, has not yet addressed its financial dilemma. In fact, it has, for the most part, tried to sweep its problem under the rug, rather than swallowing its medicine and dealing with it head-on. The truth is that many toxic assets did spill into Europe and some nations, such as Iceland, Belgium, and Switzerland have already been affected by and/or already approached their financial issues directly. Some, like Germany, however, have attempted to mask their issues, some might say, in order to stave off consumer distress, which would cripple an already fragile economy. Germany, the leading world exporter, is already suffering from heavy decreases in demand and cannot afford to suffer a collapse in consumer confidence; however, a delay in dealing with its financial problems will more than likely cause a prolonged recession and/or delayed deflationary pressure. In fact, the U.S. has called for tougher stress testing of the European banking system.
Europe is home to 5 or 6, depending on how one wants to classify Russia, of the 10 largest exporters in the world. As such, its economy is largely dependent on the health of its importers, thus creating a domino effect that inevitably encompasses China and the U.S., which, as I have stated, have fundamental issues with their own economies and are therefore unlikely to spend a significant amount of money, especially compared to that during the recent bubble period, any time soon. As such, Europe as a whole, with its strengthened currency, is likely to suffer significantly for the foreseeable future.
"So what does this have to do with gold and silver?"
As stated above, many people are buying gold and silver now, with the belief that inflation is on the horizon. In fact, there is a historic shortage of gold and silver coins, which has caused the U.S. Mint to suspend its sales several times during the past few years. Hopefully, armed with the explanation above, as well as with your own personal research, you will realize that deflation is much more imminent than inflation. (In fact, on the eve of the publication of this article, the Wall Street Journal printed a story stating that deflation is a more imminent global concern than inflation.) Therefore, it is my belief that gold and silver, which are hedges against inflation, will, in fact, drop in value over the near term as investors realize that global demand is just not there. Both metals have been relatively stable (for precious metals) in the current environment, after having shed 8% and 20%, respectively.
I suspect that gold, which tends to be much more stable than silver, could fall an additional 20%, to $750/oz., and silver an additional 30% or more to $10/oz or less. Any price below these levels, in my opinion, is a bargain and should be heavily bought... provided that the investment thesis in this article has not changed.
As for whether to buy physical gold or silver, their ETFs (GLD & SLV) or mining companies, I personally will be buying the physical versions of each and probably some mining companies as well, since producers can outperform the metals themselves, if invested in at a very depressed price. Some also offer dividend income, which can mitigate price fluctuations and increase growth potential. As for the ETFs, I believe that they hold much more counter-party risk than most, and I am very concerned that neither ETF's holdings has ever been audited.
Also, the price to own the physical assets in an account at the Perth Mint, for instance, is minimal AND since the mint is located in Australia, which has never banned the ownership of gold, unlike the U.S., I feel it is a much safer option at a minimal charge than purchasing either gold or silver through an ETF such as GLD or SLV. Plus, both precious metals, as well as others, can be bought at the spot rate, stored for a small fee, and can be taken control of physically-- if ever desired.
Lastly, here are the final reasons why I believe gold and silver pose excellent opportunities over the long-term, but only if bought at the right price, meaning, when others do not believe in their staying power or, at least, less so than in the current environment.
- China is buying gold and, rumor has it, in large quantities. As long as this information remains suppressed, gold prices should remain under $1,000/oz. If this information is confirmed and it is established that China is continuing to buy more quantities, the price of gold will skyrocket, especially since it is very likely that the price of the U.S. dollar will suffer a dramatic hit, as investors read that China has lost complete confidence in its value and is looking to unwind its position in the dollar.
Inflation will be a long-term global concern. As commodity demand returns, nations will be forced to mop up their flood of currencies from the world market in order to make goods cheaper for each country's respective citizens. Raising interest rates, however, will be a very complex problem for the U.S., much more so than other nations, as it knows just how dire its debt problem is.
While the U.S. might lead other nations out of a recession, by default of being one of the first into it, I believe that it won't be able to raise its interest rates as quickly as other nations. In fact, I believe that it will be forced to raise its rates by creditor nations, very similar to what happened during the 1970s and 80s. As the U.S. attempts to hold back interest rates, inflation will skyrocket well into the territory it was at that time, too. When it does, commodities and precious metals will be king. And gold will be the standard. On an inflation-adjusted basis, the peak price of gold in 1980 was $2,176 in today's dollars. Don't be surprised if it surpasses this level in the coming inflationary period, as the U.S. dollar becomes less and less the global reserve currency.
- Before the inflationary period comes, however, the mass of current gold holders will question whether or not inflation is, indeed, in foreseeable the future, as prices collapse and the U.S. dollar becomes the safe haven it was in March of this year. Believe it or not, the U.S. dollar will remain the safest place to be for the interim, as it is and will remain the world's reserve currency for quite some time. And when it becomes apparent that deflation is still here and looks as though it will be here for a period to come, gold will sink, just as the stock markets of the world, and precious metal holders will, in my opinion, panic and try to get out of their holdings to avoid further losses. When this point reaches a crescendo, those buying when others are selling will profit exponentially in the years to come.
Gold or Silver?
As the motto states, gold is the standard. So much so, in fact, that I believe we will see a new world reserve currency in the future based in some form on it, but this time, much more dynamic than under the Bretton Woods agreement. I don't think it is out of the question that gold could be the next world currency, as electronic banking technology has increased dramatically since 1944, to the point where consumers could pay in percentages of an ounce of gold using a debit card attached to a bank account.
As the standard, gold's price per ounce tends to be much more desirable and less volatile than silver. However, silver is more scarce and is used in many industrial processes. Although gold has many industrial uses as well, it tends to be stored, where silver requires much more room to store and is, therefore, used industrially more often, which means its supply actually deteriorates. In fact, the above ground supply of silver dropped 13% from 2007 to 2008, according to The Silver Institute.
In the 20th century, gold maintained a 1:47 price ratio to silver, with two occurrences of a ratio higher than 1:80 and two of less than 1:20. At gold's peak in 1980, this ratio was approximately 1:25. The current gold-to-silver ratio is approximately 1:70. Sufficed to say, an investment in silver in the coming buying period could be "worth its weight in gold" if the ratio reverts back to its mean, or act as gold on steroids if the gold-to-silver price ratio approaches its 1980 value.
An investment in precious metals is not without risk, however. Just ask those who invested in gold after the U.S. eliminated Executive Order 6102, the ban of U.S. citizens from owning gold, under the Ford administration. In just 21 months, gold sank 76%, from $186.50/oz on January 1, 1974 to $105.70 on September 1, 1976. However, it then rose to $850/oz on January 21, 1980 before Paul Voelker, Ronald Reagon's Treasury Secretary, waged war on inflation, causing gold to decrease in value, where it stayed around $350/oz for the better part of the next two decades before trending higher in 2002 and reaching a high of $1,002.80/oz on March 13, 2008.
I touched on the U.S.'s historical policy of gold in my article "Seek Refuge in Modern Day Communism" in May. Please feel free to visit it for more in depth information concerning this subject.
According to Onlygold.com, the current value of all the gold in the world is just $4.4 trillion. For comparison's sake, the U.S. federal government deficit for the first nine months of this fiscal year has just passed $1 trillion for the first time in history. The Obama administration's first budget projection, which was released in February, was for a $1.84 trillion deficit this year and a $1.26 trillion deficit in 2010-- both record amounts. A revised budget, which has been traditionally been released in July, will be announced in August.
Warren Buffett has stated many times, "I am fearful when others are greedy and greedy when others are fearful." As witnessed above, investors are hoarding gold; therefore, now is not the time to buy gold. I may be wrong, but if gold does drop, as I believe it will, it is most certainly going to fall much more precipitously than it will rise, based simply on supply and demand theory.
As a general rule, it is best to buy in increments, in order to avoid sudden price fluctuations. So if you believe my theory to be false, then start buying now. Personally, I will be waiting for a better buying opportunity.
Make no mistake, an extended inflationary environment is in our future... just not yet.