“Increase the Dose Continually”

December 2010

You can by inflation enable temporary spending power to cope with large quantities of products. But unless you increase the dose continually there comes a time when having destroyed the credit of the country you can inflate no more, money ceased to be acceptable as a value. Even before this, as your inflated spending creates demand, you have had claims for increased wages, strikes, lockouts, etc. I assume it will be admitted with Germany and Russia before us we do not think plenty can be found on this path. Sir Otto Niemeyer, 1925

The above excerpt, from a memorandum to the British Chancellor of the Exchequer, was in support of Britain going back onto some type of gold standard after World War I. History strongly suggests that our current trend of inflating by printing/borrowing U.S. dollars is both irreversible and unsustainable. As a result, I continue to believe the U.S. dollar will lose value at an accelerated rate. That is unless the U.S. chooses to force its wage structure down significantly, so as to become a competitive exporter and recapture some of the capital it has shipped to other countries (Figure 1).
Figure 1. Foreign Exchange Reserves Skyrocket as U.S. Competitiveness Wanes
4,500

4,000

Foreign Exchange Reserves ($ in billions)

3,500

India Foreign Exchange Reserves ($ bil.) Taiwan Foreign Exchange Reserves ($ bil.) Japan Foreign Exchange Reserves ($ bil.) China Foreign Exchange Reserves ($ bil.)

3,000

2,500

2,000

1,500

1,000

500

0 2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010E

Source: World Gold Council, Balance Capital Advisors Inc. estimates.

If the U.S. does not force down wage rates, I would expect newly minted U.S. dollars to continue to be our biggest export. However, the countries receiving our dollars should grow to believe that leaving them in U.S. dollars and/or treasuries is naïve.

Figure 2 illustrates that even though China has started to diversify their foreign exchange holdings into gold (and away from paper currencies and treasuries); they still are very exposed to paper/fiat currencies. As commodity prices (and the cost of living) rise relative to paper currencies, this puts more pressure on investors (including China) to diversify from treasuries and paper currencies. Equally important, as world tensions heat up (i.e. North Korea aggression, China’s new drones, Iranian nuclear program, etc) it is harder to know in which countries to invest. I still expect countries with a lot of foreign exchange reserves to invest in their own economies, thus making commodities and emerging market stocks good investments. However, even these countries need to increase their gold holdings and gold might prove to be the best store of value in the event of a war.
Figure 2. China Is The Largest Of Several Nations That Should Buy Gold
350% % China Foreign Exchange Reserves in Gold China Gold Tonnes 300% 1,100 1,200

China Gold as % Foreign Exchange Reserves

1,000 250%

900

China Gold Holdings (Tonnes)

800 200% 700 150% 600

100%

500

400 50% 300

0%

200

Source: World Gold Council, People's Republic of China, Balance Capital Advisors. Inc.

19 7 19 7 7 19 8 7 19 9 80 19 8 19 1 8 19 2 83 19 8 19 4 8 19 5 8 19 6 8 19 7 8 19 8 8 19 9 90 19 9 19 1 9 19 2 9 19 3 9 19 4 9 19 5 96 19 9 19 7 9 19 8 9 20 9 0 20 0 0 20 1 0 20 2 0 20 3 04 20 0 20 5 06 20 0 20 7 0 20 8 20 09 10 E

Figure 3 illustrates the largest sovereign holders of gold and the value of such as a percent of their foreign exchange reserves. Most developed nations were effectively on the gold exchange standard until August 1971, at which point the U.S. ceased to allow foreign exchange reserves to be redeemed for gold. U.S. gold holdings fell from a peak of roughly 20,000 tonnes in the 1950s to 8,000 tonnes (roughly where it is reported now), as foreign countries redeemed paper currencies for gold. I point this out because I think a gold standard, which effectively commits governments to exchange mass quantities of gold for paper currency at some predetermined exchange rate, builds trust.
Figure 3. Gold Holdings as % Foreign Exchange Reserves
90%

80%

70%

60%

50%

40%

30%

20%

10%

0%

Italy

Venezuela

United States

Netherlands

Switzerland

Portugal

Germany

Philipines

Libya

ECB

Saudi Arabia

Lebanon

France

Singapore

Taiwan

Japan

India

Austria

Source: World Gold Council, Balance Capital Advisors. Inc.

Currently, I believe international tensions are at least being exacerbated due to the potential decline in the value of U.S. dollar foreign exchange reserves relative to commodities (including gold). In other words, the absence of a gold standard is likely contributing to international tensions. In addition to spending their foreign exchange reserves on infrastructure development, I expect most countries at the right side of Figure 3 to increase gold holdings as a percent of their foreign exchange reserve (i.e. replicate a gold standard). Just to put it in perspective, for the countries right of the Philippines to get to a 15% gold weighting (still relatively low) they would need to buy nearly all the gold from the other 15 countries in Figure 3.

United Kingdom

Belgium

Algeria

Russia

China

Spain

The quote at the beginning of this note suggests that money printing has historically been bad for an economy, and I agree. Figure 4 illustrates that since the U.S. went off the gold exchange standard in 1971 the country has “increased the dose” of money printed. Not coincidentally, U.S. treasury debt has gone up at a similar increasing rate. Although U.S. wage rates are relatively high, they have not kept up with general inflation and as a result both governments and individuals borrow. Increasingly, such borrowing is required just to maintain the status quo.
Figure 4. Increasing Doses of U.S. Money Printing and Borrowing are Necessary
$2,500 US Monetary Base US Treasury Debt $2,000 $12,000 $14,000 $16,000

US Monetary Base ($ in millions)

$1,500

$10,000

$8,000

$1,000

$6,000

$4,000 $500 $2,000

$-

$-

Source: www.usgovernmentspending.com, Balance Capital Advisors Inc. estimates.

19 70 19 72 19 74 19 76 19 78 19 80 19 82 19 84 19 86 19 88 19 90 19 92 19 94 19 96 19 98 20 00 20 02 20 04 20 06 20 08 20 10 E

US Treasury Debt ($ in millions)

As a major holder of U.S. dollars and treasuries (i.e. U.S. liabilities), certain governments should be nervous because the history lesson is that the money printing needs to continue until the money “ceases to be acceptable as a value”. The need for increasing doses of money printing/borrowing becomes clear as one looks at the total debt of the U.S. economy compared with federal tax receipts (Figure 5). Increasing credit in any form will ultimately hurt economic output (and related tax receipts), yet the Federal Reserve has continued to encourage such. I believe this is because our economies fixed debt and wage structure would make a healthy deflationary deleveraging too painful in the very short run. Kicking the can down the road a few years is more palatable, largely because most Americans are not familiar with the ultimate consequences of this delay tactic.
Figure 5. Economic Output Does Not Keep Up With Credit Creation
$3,500 Federal Tax Receipts Total US Debt (ex. Corporations) $3,000 $120,000 Total US Debt (ex. corporate debt, $ millions) $140,000

US Federal Tax Receipts ($ millions)

$2,500

$100,000

$2,000

$80,000

$1,500

$60,000

$1,000

$40,000

$500

$20,000

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

Source: www.usgovernmentspending.com, Balance Capital Advisors Inc. estimates.

A friend of mine recently said to me “you are an end of the world kinda guy” and I want to address that affectionate description (lol). If you have traveled the world and/or extensively researched history, I think it is easier to appreciate how fortunate most Americans are to be both free and relatively wealthy. However, unless one has lived in an oppressive third world country (I have not) I do not think you could really appreciate our fortunes. I believe our Constitution is essential to American freedom and progress, and have little doubt that it will be the bedrock that will support us going forward. However, our monetary system is increasingly unrelated to our Constitution and for decades now we have been undermining the value of our currency to enhance an already good situation (Figure 6).

2010E

Figure 6. US Money Printing Has Driven The Dollar Value Down For Decades
$1.00 Dollar Value in Gold Terms (1971=$1) $0.90 US Monetary Base $14,000 $16,000

$0.80 $12,000

US$ Value in Gold Terms (1971=1)

$0.70 $10,000

$0.60

$0.50

$8,000

$0.40 $6,000 $0.30 $4,000 $0.20 $2,000

$0.10

$0.00 2010E 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990 1989 1988 1987 1986 1985 1984 1983 1982 1981 1980 1979 1978 1977 1976 1975 1974 1973 1972 1971

$-

Source: U.S. Federal Reserve, World Gold Council, Balance Capital Advisors Inc.

The greed that has driven the money printing has inflated our lifestyle, to such a level that we are now uncompetitive and, in many cases, necessary importers of numerous commodities and/or goods. I continue to believe that Americans will vote for healthy entitlements and social safety nets (i.e. for more dollars to be borrowed/printed), but when no more can be printed then I hold some confidence that Americans will embrace a healthy healing process. In the meantime, I encourage investors to protect the savings they have. Finally, I can understand how all the gold commercials and newspaper articles make it feel like gold is in a bubble. If every government stopped printing money tomorrow, then maybe that would be the case. As discussed, I do not expect that to happen. Instead, I think gold and silver are still in the early stages of a bull market both fundamentally and by historical standards (see next chart). If I am right, this does not preclude corrections of up to 20% in gold prices (more likely 5%, however). Of note, I think most other commodities are potentially earlier on in their respective bull markets. For this reason, I think emerging markets that have large foreign exchange reserves and could benefit from higher commodity prices should be good part of ones portfolio as well.

Ronald A. Tadross, CFA ∙ Balance Capital Advisors, Inc. ∙ www.balancecap.com
DISCLAIMER: THIS RESEARCH REPORT DOES NOT INTEND TO MAKE AN OFFER OR SOLICITATION FOR THE SALE OR PURCHASE OF ANY SECURITIES. INVESTMENTS INVOLVE RISK AND UNLESS OTHERWISE STATED, ARE NOT GUARANTEED. BE SURE TO FIRST CONSULT WITH A QUALIFIED TAX AND/OR FINANCIAL ADVISER BEFORE IMPLEMENTING ANY STRATEGY DISCUSSED IN THIS RESEARCH REPORT.

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