Embry represents the good guys in ROB-TV debate on markets Wednesday


By John Hathaway, Manager
Tocqueville Gold Fund
February 14, 2004

In a Jan. 4 speech this year, Federal Reserve Governor
Ben Bernanke opined that the rising gold price was
caused by terrorism. Geopolitical tensions, he said,
"account for the bulk of the recent increase in the real
price of gold."

Bernanke also downplayed the weakness of the dollar.
Weakness against the euro was less important than
the fact that the dollar's "real value against the currencies
of important U.S. trading partners, weighted by trade
shares, has fallen only about 12 percent from its peak
in the first quarter of 2002."

Bernanke's remarks in total formulate the rationale for
the Fed's easy money policy. As such, they illuminate
reality as perceived by the Fed versus reality as
perceived by the rest of humanity.

Bernanke's references to the "real" price of gold and the
"real" value of the dollar suggest that he and his
colleagues have access to information and knowledge
unavailable to ordinary citizens. Policy decisions, and,
most specifically, the Fed's ultra-easy money stance,
are based on these "realities." Those of us who believe
that the price of gold is rising in response to easy money
as well as repeated interventions in past and prospective
capital market crises have got it all wrong. Those who
fear that the overvaluation of the dollar and resulting
capital market imbalances may spell trouble for the
financial markets and the economy can toss out the

There are three ways to assess the worldview of the
Fed governors.

First, they are indeed right. Critics should just simmer

Second, what the governors say for public consumption
(and the Fed has become increasingly vocal in recent
years) is primarily designed to affect the behavior of
consumers, corporations, and other governments in
order to achieve desired results such as economic
growth, financial market tranquility, and retention of
dollar holdings by foreign central banks. In other words,
they don't believe what they are saying but are using
the Fed pulpit to achieve policy objectives.

Third, and most disturbing: They actually believe what
they are saying.

What is the "real" value of a dollar?

It is a question of metaphysical dimensions. The dollar
is the unit of account by which all participants in the
economic process make decisions. Whether or not to
buy, hire, produce, or invest depends on millions of
daily calculations measured in dollars.

Decades ago -- 33 years to be exact -- dollar-centric
decisions were pretty much confined to the borders
of the United States. The 1971 decision to decouple
the dollar and gold marked the beginning of an
explosion of international reserves. It gave birth to the
dollar-based system of global credit and an era of
unprecedented world prosperity. Today the
preponderance of global economic decision making
is rooted in some notion as to the intrinsic value of a
dollar expended, received, or held as an investment.

For the dollar to continue as the global numeraire, it
is essential that its value remain stable. What
participants in the economic process believe the
value of the dollar to be has the power to affect global
economic activity. There can be no room for doubt as
to the dollar's value either in the present or in the

The enticing question is: What information should the
market use to assess the dollar?

Should it use the price of gold?

Not according to Governor Bernanke.

Should it use exchange rates? Again, the answer is no.

Let us then turn to the mini-maestro for the correct

He concludes his Jan. 4 speech this way:

"The achievement of price stability must not and will not
be jeopardized. We at the Federal Reserve will closely
monitor developments in prices and wages, as well as
conditions in the labor market and the broader
economy, for any sign of incipient inflation. We will also
look at the information that can be drawn from surveys
and financial markets about inflation expectations. For
now, I believe that the Federal Reserve has the luxury
of being patient. However, I am also confident that,
when the time comes, the Fed will act to ensure that
inflation remains firmly under control."

In other words, "trust us" to get it right.

But is Bernanke's confidence that the Fed will act
appropriately to maintain the dollar's value enough to
dispel all doubts?

Perhaps central bankers in Asia have not yet had a
chance to digest Bernanke's words. This might explain
the Jan. 28 comments of Japanese Finance Minister
Sadakazu. He said he wanted to carefully consider
whether to change the weighting of gold in Japan's
foreign reserves, which are "mostly made up of
dollar-denominated assets."

Japan's reserves reached a record high of $673 billion
at the end of December 2003.

Zhu Min, general manager and advisor to the president
of the Bank of China, the largest holder of dollar reserves
in China, recently stated: "All the Asian countries hold
dollars for security reasons, but at some point this has
to end." Speaking at the Davos World Economic Forum
in January, he added, "Over time, China's pace of export
growth would wane, weakening its ability to buy
dollar-denominated assets."

Central bankers, upon concluding that they hold more
of a particular reserve asset than they desire, have
been known to act without any consideration of
intrinsic value. One need only recall the relentless
divestment of gold holdings by European central banks
at prices well below the current market. That episode
alone suggests that central bankers are either
incapable of judging or indifferent to matters of

By now, any literate investor knows there are too
many dollars held by Asian central banks, but nobody
can figure out what happens next.

For example, it is obvious that if they were to sell, or
even stop buying, the ever-increasing supply of U.S.
Treasury debt, interest rates in the United States would
rise substantially. The less obvious but inescapable
side-effects would be lower stock prices, higher inflation,
and a softer economy.

This could also cause dislocations in China, which needs
the U.S. market to provide job growth.

In a recent article in Foreign Affairs ( November/December
2003) David and Lyric Hughes Hale wrote: "The unemployment
rate in (Chinese) urban areas is estimated at more than 8
percent; there may be an additional 200 million jobless
workers in the countryside. According to Zhai Zhenwu,
the director of the Population Research Institute at China's
Renmin University, China will need to create 20 million new
jobs a year to absorb the 8 million people who have lost
their jobs in state-owned enterprises."

It seems unlikely that Chinese bureaucrats would initiate
any precipitous move away from the dollar, either in the
composition of their reserves or in the manipulated peg
of 8.3 renminbi per dollar. It is more plausible that external
events will impose change.

Still, financial officials in Asia are telegraphing creeping
abandonment of the dollar.

Stephanie Pomboy of Macromavens notes that the percentage
of Chinese foreign exchange reserves recycled into
Treasuries declined to 24 percent in the second half of
2003 from 54 percent for all of 2002. These signals alone
may prove sufficient to accelerate the dollar's slide from its
perch as the global numeraire.

Perhaps a resurgence of U.S. protectionism based on the
issue of job losses will add momentum.

Spreading credit worries tied to deflation of the Chinese
bubble, an unexpected global downturn, or a sharp rise
in interest rates are also capable of greasing the skids.

One could speculate endlessly on the scenarios. It is
impossible for anyone to write tomorrow's headlines. But
what is absolutely and irrefutably certain is that oversupply,
a term without which it would be impossible to describe the
dollar, will be corrected by market forces in due course.
The Fed, notwithstanding its privileged knowledge of the
true value of the dollar, is powerless to dictate that the
dollar will trade for one penny more than its
market-clearing price.

The presence or absence of value cannot be determined
apart from a context of scarcity or abundance. Value is
also inextricably tied to usefulness. Water may be cheap
in most parts of North America, but in the Sahara it can
be priceless. The hard-pressed debtor may thirst for a
few dollars, but not the rock star.

While the principle is easy to apply locally, it is more
challenging on a global scale. The earth is 80 percent
water and so, for most, it is relatively cheap. Essential
to life itself, water can be very expensive.

The value of money is fundamentally different from all
other daily necessities. Money is useful both for its
current transaction value and for its future purchasing
power. While its transaction value can be known at
any given moment, future purchasing power is a matter
of speculation.

Money should not be confused with currency. Real
money is scarce. A five-million Turkish lira note sits on
my desk. There are plenty more where it came from.
Its utility ends with its curiosity value (and its
transaction value for those in Turkey). Otherwise, a
low opinion of the Turkish lira is shared universally.
No central bank accumulates the Turkish lira as a
reserve asset. Its future purchasing power is expected
to decline because the issuing authority lacks any
credible commitment to maintaining its current value.
To hold more of a currency than one requires for daily
transactions, one must believe that its future
purchasing power will approximate that of today.

The Federal Reserve would have us believe that the
inherent value of the dollar is best represented by the
Consumer Price Index. The American Institute for
Economic Research informs us (Jan. 12, 2004,
Research Report) that this measure of the general
price level was introduced in World War I at the
request of President Wilson to help mediate disputes
between labor and management in defense-related
industries. Its use spread over the next several
decades, almost always in relation to wage issues.

By the 1960s and 1970s it became the basis for
cost-of-living adjustments for benefit packages,
including Social Security. The index, compiled and
published by the Bureau of Labor Statistics (BLS), is
the most widely used and trusted barometer of the dollar's
value. It is the basis for calculating the excess return
on Treasury Inflation-Protected Securities (TIPS) and
real interest rates (T-bills minus trailing 12-month CPI).
It is the method by which investors calculate their
inflation-adjusted returns from government bonds and
private-sector debt securities. Since short-duration
government bonds approximate risk-free return, the
CPI indirectly but most powerfully influences the
valuation of the entire equity market.

What started out as a fairly simple and pragmatic
attempt to hammer out equitable wage settlements
some 90 years ago has become a complicated,
politically charged, and controversial cornerstone for
the capital markets.

The BLS, in a never-ending and earnest effort to keep
up with the times, has changed the items, the
composition, and the pricing methodology of the CPI
components. It has distinguished between core inflation
and reported inflation to iron out unsustainable
fluctuations in commodities. It has introduced seasonal
adjustments to smooth out comparisons on a
month-to-month basis.

The index currently contains 400 items thought to
approximate a market basket of goods and services that
best represent the general price level.

In recent years the index has been tame, advancing at a
rate of 1.9 percent for the last 12 months, and down from
2.4 percent for 2002. The signal transmitted to the capital
markets is that there is little or no inflation and therefore
the value of the dollar is rock-solid.

In fact, the Federal Reserve has been more preoccupied
with potential deflation, or a general decline in the price
level. The expectation of low CPI readings for the
foreseeable future is a key justification for the Federal
Reserve's aggressively accomodative stance on interest
rates, the lowest bond yields since the 1950s, and the
highest equity market valuations since the dot-com crash
of 2000.

Arnirvan Banerji, director of research at the Economic
Cycle Research Institute, scrutinizes CPI data for hints
about potential changes in direction. The Future Inflation
Gauge or FIG has fairly reliably anticipated changes in
direction with lead times of several months. The FIG,
according to Banerji, is currently forecasting a further
decline in the CPI, more good news for the capital
markets, or so it would seem. He hastens to add that
the FIG is helpful only in pinpointing changes in direction
of the CPI. It does not capture the amplitude of an
imminent rise or decline in the CPI. It also cannot
detect secular shifts in magnitude that span more than
a single business cycle.

This leading analyst of the CPI questions whether the
information conveyed by the series is as meaningful as
the financial markets take it to be. In a very effective
sound bite heard by this listener on Bloomberg radio,
Banerji said that a person with one foot in boiling water
and the other in a bucket of ice is on average perfectly
comfortable. So it would seem that the tranquility of the
CPI does not capture underlying turbulence.

The thematic cross-current would be one of rapidly
escalating price levels for goods and services that are
in scarce supply or have some measure of pricing power
such as health care or raw commodities. On the other
hand, price deflation is evident in many consumer goods.

Some 16 percent of the 2003 sales of Wal Mart (purveyor
of many of the 400 items measured in the CPI) sales were
sourced in China. At the current exchange rate for the
renminbi, this percentage will undoubtedly grow and keep
a ceiling on consumer good prices.

Thanks to Asian outsourcing, the BLS was able to report
declines of 83 percent in computers, 56 percent in
televisions, 18 percent in women's dresses, 7.8 percent in
sports equipment, and 1.7-5.1 percent in other apparel
categories for the period 1990-2003.

For the same period, the all-item average rose 46 percent.
Over the same period, college and tuition fees rose 171
percent, cable television 115 percent, bank services 104
percent, motor vehicle insurance 85 percent, and movie,
theater, and sporting event tickets 82 percent.

But there is more to this than simple crosscurrents,
according to Banerji. Several years ago the very important
housing component of the CPI was increasing at an annual
rate of 4 percent. Today that number is 2.2 percent and
heading lower. Housing is weighted at 40.85 percent of the
total CPI.

How is it falling when house prices are rising? Simple. The
BLS calculates this important component on the basis of
"imputed rent" rather than the capital cost of buying a new
home. Imputed rent synthesizes the cost of home
ownership into a rental factor putting all people, both renters
and homeowners, on the same footing. The BLS gathers
the information for imputed rent, or the "Owners' Equivalent
Rent Index" by asking "each homeowner (surveyed) for
their estimate of the house's implicit rent and what the
occupants would get for their rent ... if the owner did rent
their home." (U.S. Department of Labor Program Highlight
Fact Sheet No. BLS 96-5.)

It should be noted that in light of the Federal Reserve's
highly expansionary monetary policy, single-family
owner-occupied housing has enjoyed an unprecedented
construction boom. Banerji observes that a felicitous (for
the CPI) consequence of the single-family housing boom
has been a rise in vacancies and a decline in rental rates
for apartment properties. Pressure on the rental market
appears to go a long way toward explaining the mystifying
decline in the housing component of the CPI. Could it be
that the sagging apartment rental market also explains
rising bond and equity markets?

There is still more to the tale. Gertrude Stein's famous
dictum -- "A rose is a rose is a rose" -- speaks to the
mutation of a word's meaning over decades or centuries
of use. We can surmise that Big Brother is alive and
well at the BLS, where a computer is not a computer is
not a computer. In other words, added features, memory
capacity, and random bells and whistles are not captured
in the straightforward list price of a computer.

To expunge all continuity of meaning, the BLS brought
forth "hedonics," the science of measuring the value of
a product or a service after allowing for qualitative
improvements. A laptop with twice the memory as last
year's model but sold at the same price this year is
counted as a 50 percent price reduction.

This sort of analysis was applied initially to computers and
IT equipment. More recently, a broad range of consumer
goods including electronics and automobiles has been
subjected to hedonic measurement.

Health care has been a particularly ill-behaved sector of the
CPI. For example, hospital services, nursing homes, and
adult day care increased 141 percent over the period 1990
to 2003, versus an average of 46 percent for all items
measured. It should come as no surprise, then, that the
Bureau of Economic Analysis is considering adjusting
prices of medical services for quality changes (Grant's
Interest Rate Observer-1/30/04.)

Proponents of hedonic price measurement admit that the
process is not without flaws. In a July 12, 2001, paper,
Jack Triplett of the Brookings Institution found that "the
hedonically based computer equipment deflators in the
national accounts of OECD countries recorded ... ranged
from +80 percent to 72 percent for the decade of the

Happily, after the misadventures of the 1980s, the European
practitioners of hedonics achieved a "smaller dispersion" by
the early 1990s, when the computer deflators ranged from
"-10 to -47 percent."

The notion underlying hedonic adjustment is that normal price
measurement techniques fail to capture qualitative
improvements. However, we are entitled to ask whether there
are any objective standards by which these price adjustments
are applied. Why should an increase in memory capacity
processing speed equate to a price reduction? By what factor
are auto prices reduced because of airbags, catalytic converters,
seat warmers, or tinted glass? Should health care costs be
adjusted downward because patients are discharged in two
days rather than three?

Hedonic adjustments, as with pro-forma earnings, require a
great deal of subjectivity to rearrange reported information into
a new kind of reality. Slashing reported list prices for a
computer because of advanced specifications over last year's
model implies that there is quantifiable improvement in
productivity or output. As noted in Grant's (Feb. 16, 2001)
a computer, "like a piano, depends on the individual at the
keyboard: He may play the 'The Moonlight Sonata' or 'Happy
Birthday.' The implication of hedonic adjustment is that the
computer-using U.S. workforce studied at Julliard."

We must address one final layer to understand the mystery
of price stability in the midst of a falling dollar, rising
deficits, and ongoing trade imbalances. The problem goes
further than the constant rejiggering of the index or the
application of abstruse price measurement techniques.

The problem is that the prices that are being measured are
themselves fake.


Blame it on manipulated exchange rates.

Does the dollar trade at 8.3 renminbi or 105 yen because of
intrinsic value?

Asian governments that peg or manipulate their currencies to
these levels have no interest in value. An undervalued renminbi
is needed to create jobs and investment. It is for the United
States "an unholy partnership with its Asian creditors. They
would produce; we would consume. ... The United States and
its lenders have entered into the biggest vendor-financing
scheme in the history of borrowing and lending."

As a result, "the prices are fake. The exchange rates are
manipulated, the interest rates are adulterated, and the
product prices are contrived." (Grant's 1/16/04.)

What prices would the CPI measure if the U.S. dollar
bought only half as many renminbi, rupee, or yen?

The valuation of the dollar as supported by the CPI is a
testament to institutional inertia, delusions of elitist
intellectuals, and public gullibility. The myth of price
stability conveyed by the CPI would shatter upon contact
with freely floating exchange rates.

The CPI was conceived to measure price levels within the
borders of the United States. It was thought to convey
helpful information to consumers, managements, and
investors as to the presence or lack of price stability. It
did so in a context of stable exchange rates and
international trade flows that are miniscule by today's

Thanks to the evolution of financial markets and trade
reform, the dollar is a borderless currency. For the
substantial holders of dollars outside of the United States,
the notion that a benchmark so flawed as the CPI should
be the preeminent measure of value is laughable.

Extraterritorial dollars are held not for consumption but for
investment. The more astute holders of these dollars must
look beyond the CPI to the future supply and demand for
the currency.

In assessing those fundamentals, they must take into
account the integrity of the issuing authority. They must
also evaluate the suspect reliability of the principal and the
only readily available measure of the currency's value, the
consumer price index.

As for future supply and demand, Richard Duncan remarks
in the Financial Times: "The amount of new yen that Japan
'printed' and converted into dollars during January 2004
alone was enough to finance 13 percent of the U.S. budget
deficit." Earlier in the column, he states: "It is
inconceivable that economic policy makers in Tokyo and
Washington do not understand the impact that this
unprecedented act of money creation is having on global
interest rates and economic output."

In its infancy, the CPI was a tool for settling disputes, not
a measure of the dollar's value. In those days $20 bought an
ounce of gold and that was the measure of the currency's
value. It was simple to understand for one and all. Armies
of bureaucrats, statisticians, and academicians were not
required to collect, massage, interpret, or invent obscure
information in order to divine the dollar's value. No financial
high priests comparable to today's Fed were needed to
reveal the truth.

Credibility of the currency rested simply on its link to gold.

The dollar's viability as the cornerstone for international
credit is in jeopardy. The overvaluation of the dollar cannot
help but breed further capital misallocation, production
overcapacity, inflation of asset values, and debt buildup,
all precursors to another bubble.

How will world financial authorities orchestrate a graceful
retreat for the dollar from center stage?

The possibility of an orderly, well-choreographed exit seems
remote. Whether it goes out with a bang or a whimper, the
end game will be deflationary.

Bob Hoye of Chartworks (Feb. 6) observes: "Central bankers
merely assist the credit expansion that, by necessity, is
hypothecated against rising asset prices. Once the top is
in, the power inevitably shifts to margin clerks (whose)
mandate is to get the accounts on side and, after rampant
speculations, that means selling into a collapsing market."

The perceived safe havens offered by the euro or the yen will
eventually yield only losses. While these currencies provide
a liquid alternative in the short run, their fate is inseparable
from the dollar. The three are like inebriated celebrants
wobbling home, propping each other up and incapable of
orbiting too far from their collective gravity. The day when
each becomes confetti is within sight.

What is the value of a dollar?

For us, the simplest and most reliable measure is the
amount of dollars required to buy a fixed quantity of gold.
We respectfully disagree with Bernanke. Whether he and
his fellow governors are hypocritical or delusionary in their
assessment of the dollar's intrinsic worth is of no matter.

What is important is that they are flat-out wrong. As anyone
can see, the dollar is falling against gold and has been
doing so for almost five years, long before terrorism became
a front-page item.

As we are very busy figuring out how to profit from the view
that it has much further to fall, we have given little thought
on how to fix the mess. Let us leave financial diagnosis and
prescriptions to those wise policy makers who got us here.

Still, we cannot resist offering some friendly advice. The
next time around, respect history. Anchor a new global
currency to something that has real monetary value.


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