John Hathaway: Beardsley Ruml''s Road to Ruin, Part 1


11:19p ET Sunday, November 7, 2004

Dear Friend of GATA and Gold:

John Hathaway, manager of the Tocqueville Gold Fund,
has just written a long analysis of the prospects for
gold and the world financial system, "Beardsley Ruml's
Road to Ruin." Hathaway's work may be especially
satisfying to GATA supporters for quoting from the
speech given to the June meeting of the London
Bullion Market Association in Moscow by Oleg V.
Mozahaiskov, deputy chairman of the Bank of Russia
-- a speech suppressed by the LBMA but liberated by
GATA through an official English translation provided
by the Bank of Russia after much negotiation.

The Tocqueville Internet site seems to have been out
of order most of today but it was operational long
enough for us to copy Hathaway's essay for passing
along to you below, minus its charts, which can be
viewed only when the Tocqueville site resumes

Hathaway's work, while compelling, is long, so please
forgive its transmission to you in two parts.

CHRIS POWELL, Secretary/Treasurer
Gold Anti-Trust Action Committee Inc.

* * *

Beardsley Ruml's Road to Ruin

By John Hathaway
Tocqueville Funds
November 4, 2004

Gold and gold shares have spent the year to date
in a corrective mode.The intense investment ardor
of 2003 has been succeeded by indifference and
skepticism.Gold shares, which are essentially
long-dated options on the gold price, provide the
best barometer of sentiment.In 2002 and 2003
the shares outperformed the metal by a factor of
2:1. This year, they have underperformed, with
gold up 2 percent and the shares down 9 percent
(basis XAU as of November 2, 2004.) Investment
flows into U.S. gold mutual funds have been
subdued compared to 2003 and 2002, and are
down more than 60 percent.

As always, the key investment questions are:
1) where are we on the road map of the secular
bull market for gold; 2) are we in fact still on the
road or has it come to an end; and 3) what is the
condition of the fundamental forces behind the
market direction?

To alleviate any suspense, it is our view that we
are still in the early stages of a bull market for
gold and a bear market for financial assets,
including (especially) the U.S. dollar. Our view on
1 ought to dispatch any need to discuss 2, but it
might be worth considering what to look for in
judging the bull market in gold to be over. In
general, the answer to 3 is that the conditions
supporting a rising price of gold are not only
intact but, if possible, stronger than ever.

... A Brief Review of the Fundamentals

Supply and demand factors remain positive and
compelling.One might think that after a five-year
run in the gold price from $250 to $400+, mine
supply would be surging and demand would have
receded.In fact, the opposite is true. Mine supply,
at 2,500 tonnes (metric), seems likely to decline
over the next three to five years. This would likely
be true even if the gold price traded up $100/oz.
and remained on this hypothetical new plateau.
Demand is robust.

Gold mining is an intrinsically hardscrabble
proposition. It is rarely a good business.Rising
costs have more than kept pace with the rising
gold price.In South Africa, producer of 14 percent
of the world's gold, an overvalued currency has
resulted in a declining gold price in local currency
terms, contracting margins, and shutdowns of
marginal mines. Elsewhere, important cost factors
have pinched returns on sales and capital. Energy
costs have seriously eroded margins for open-pit
mine operations worldwide. Equipment and capital
goods price increases have drained cash not only
for existing operations but have raised the ante for
new mines on the drawing board.Drill rigs are hard
to find, skilled operators even more so, and assay
lab backlogs are at record levels. The industry,
broadly ignorant of the need to generate returns in
excess of its cost of capital, has high-graded
existing mines, overproduced relative to reserve
development, continues to squander capital, and
persists in opting for dilutive financings that
undermine the interests of shareholders (thereby
turning away all but the most speculative investors.)

Poor returns on capital and value-destroying mergers
have caused significant cutbacks on exploration
spending, which remains 40 percent below the recent
peak of $1.7 billion in 1997. The efforts of
environmental NGOs, emboldened by the financial
support of tree-hugging billionaires, are adding costs
and challenges unknown 10 years ago for existing and
proposed mines.The lead time between discovery and
first output for major new mines is easily measured in

Demand for gold jewelry remains strong despite higher
prices. According to Goldfields Mineral Services,
global consumer demand rose 11 percent in terms of
tonnage and 25 percent in dollars in the second
quarter versus last year. The Indian subcontinent, the
largest market, will purchase 880 tonnes this year, a
rise of 10 percent according the MMTC, the Indian
parastatal agency that tracks commodity imports.
The pattern of Indian buying, which accounts for 19
percent of world jewelry consumption, has been to
absorb gold on declines but not to drive prices on the
upside. The financial market metaphor would be that
of intelligent accumulation. India, though significant
in itself, exemplifies the increased appetite for gold
that goes along with Third World economic growth.
Elimination of import tariffs in China and the
organization of the Shanghai Gold Exchange
promise to activate demand in a potentially large
market that has been a non-factor for the past

Central bank bullion bars and new mine output are
sold for cash, only to be melted down in refineries
and reconstituted into fabricated shapes for jewelry.
In this manner, gold disappears into the dowries of
Asian families and is no longer for sale. Physical
buying of this sort not only absorbs supply; it
places gold beyond the grasp of financial traders
and issuers of derivatives such as gold-linked notes.
These traders are the equivalent of gold price
bookies with little idea of the internal fundamentals
of their bets and absolutely no idea of the widening
gap between the liquidity of gold traded as paper
and the real thing.

There are two factors driving demand for physical
gold.The first is the growing prosperity of the
emerging world.The second is the rising level of
commodity prices, which acts as an important
cash-flow generator for segments of the globe
where derivatives are unknown or distrusted.

While Third World jewelry demand sops up nearly
all newly mined gold every year, investment
demand also shows signs of awakening.Investment
demand for gold as an alternative asset has been
dormant for 25 years. Awakened, it has the potential
to swamp the supply of physical gold, which in
financial market terms is similar to a microcap

We estimate that the market cap of global gold to
be approximately $1 trillion at current prices,
assuming that all central bank gold is for sale.
Since all central bank gold is not for sale, the real
market cap is approximately half of this figure.
Global financial assets approximate $70-$75 trillion.
Even a small diversion of one tenth of 1 percent from
financial assets into gold would equal two years of
mine supply. It is a trade that can't be done at current

It will be interesting to see what becomes of the new
gold ETF (exchange-traded fund) proposed for New York
Stock Exchange listing. The ETF must be backed by
physical gold, to be held on deposit with HSBC in
London. It is our belief that, in time, the ETF will tap
investment demand that until now has steered well
clear of the sector. An ETF launched in 2003 in
London has achieved a market cap of $739 million
and is backed by 1.8 million ounces (as of Oct. 19).
A NYSE listed gold-backed security, in our opinion,
will be more widely accepted. It will be followed by
listings on other major markets.

Conservative investors, both institutional and individual,
have shied away from mining stocks for good reason.
They are risky and speculative, even if they do provide
dynamic exposure to rising gold prices. Institutions
loaded with overvalued equities and bonds would do
well to consider the non-correlated benefits of even
a small commitment to physical gold, for the sake
of their beneficiaries who will need spending power
20 to 30 years from now. Individuals and institutional
portfolio managers may well come to consider the
ETF as a more effective way to protect capital than
by simply raising cash.The ETF has the potential
to add several hundred dollars to the gold price, over
time, because it will facilitate access to gold for a
broad range of investors previously excluded due
to inexplicably archaic mechanisms.

And what of central bank selling, the long-standing
hobgoblin for gold investors?

In short, there are signs that overt official sector
selling may be abating. Although the new agreement
governing central bank sales (Central Bank Gold
Agreement, March 8, 2004) permits 2,500 tonnes to
be sold over the next five years, only 1,900 tonnes
has been spoken for.The UK has completed its
sales and Swiss have a residual of 130 tonnes. The
Netherlands has a small residual of 65 tonnes from
its original program of 300 tonnes.According to
Gold Fields Mineral Services, it is "highly improbable
that, in practice, close to two-thirds of this quantity
would be mobilized for sale" over the next five years.

Central bank attitudes toward gold appear to be
warming. There is official sector buying in the Persian
Gulf. Argentina has purchased 40 tonnes of gold this
year, possibly as defensive move against aggressive
creditor actions outside the country.Official sector
antipathy to the dollar is spreading. A scathing June
2004 review of the "dollar hegemony" by Oleg V.
Mazhaiskov, deputy chairman of the Russian central
bank, is undoubtedly on the minds of others who feel
more constrained to speak freely:

"The world has come to a paradoxical situation in
which the creditor countries are more concerned with
the fate of the dollar than the U.S. authorities
themselves are. Thus the evolution of the U.S. dollar's
reserve role in recent years has given ground to some
quite pessimistic forecasts, based on rational
economic theory.No wonder that the number of people
who have held assets in dollars and now wish to
diversify them partly into gold -- the traditional shelter
from inflation and political adversity -- is steadily

Central bank supply, required to balance the market at
current levels, is waning.Increased investment demand,
a wider appreciation on the constraints of new mine
supply, and a decline in central bank selling are the
stuff of a compelling commodity story.But there is
much more to this story than the pedestrian summation
of supply and demand factors.

... Enter Beardsley Ruml

The DNA of financial instability is embedded in human
nature. Manic highs, gut-wrenching lows, expansive
assumptions as to future returns, catatonic withdrawal
into risk avoidance, and a predisposition toward optimism
or skepticism all originate in the psyche. They are
magnified, reinforced, and institutionalized by crowd
behavior.The ebb and flow of the tide of credit reflects
the rhythmic cycling of popular beliefs and fears over

The credit cycle explains how the mythic business
heroes and investment icons of one year are
transformed into the laughingstock and felons of
another. It cannot be harnessed by econometric
exactitude to suit the aims of public policy, because it
is a fundamental expression of humanity at work in the
financial marketplace. Still, for most politicians, the
lesson learned from the 1930s depression was that an
expanded government role could modify market
outcomes to benefit society.

It is in the context of social engineering that the removal
of gold from its historical role as the official basis for
money, the substitution of fiat money as the foundation
for the international credit system, and the consequent
mispricing of gold must be understood. Thirteen years
after President F.D. Roosevelt suspended private
transactions is gold, the chairman of the New York
Federal Reserve penned an article for American Affairs
titled 'Taxes for Revenue Are Obsolete.' Beardsley
Ruml, advocating the elimination of the corporate
income tax, observed:

'The necessity for a government to tax in order to
maintain both its independence and its solvency is true
for state and local governments, but it is not true for a
national government.Two changes ... have substantially
altered the position of the national state with respect to
the financing of its current requirements.

"The first of these changes is the gaining of vast new
experience in the management of central banks. The
second change is the elimination, for domestic
purposes, of the convertibility of the currency into
gold."(American Affairs, January 1946)

In these few sentences, Ruml anticipates the 60-year
transformation of the Federal Reserve from a traditional
central bank into a central planning agency.Ruml, as
did many other postwar leaders, mapped out an
intellectual framework for interventionist economic
policies designed to eliminate the pain of bad economic
outcomes while presumably allowing for open-ended
upside.From that point on, the only thing that has
changed is the evolution and perfection of technique.

Ruml could never have imagined the gyrations by which
the future Fed would slay any and all dragons threatening
financial stability.Writing gold out of the monetary script,
as foreshadowed in these remarks, was the magic formula
by which the levers of credit would be transferred from the
markets to the politicians.

The U.S. dollar, freed from the constraint of gold backing
in 1971, became the pliable foundation for international
credit. It rose geometrically in quantity to become the
essential fuel of global economic growth. Owing to surfeit,
it is on the brink of global distrust. Because of its pivotal
role, few dare to speak of it honestly as did Mr.
Mazhaiskov.That is because it is more widely held, it
seems, than Internet stocks at the top. Those with large
positions can ill afford to point out its shortcomings.

Global trade has been lubricated by universal acceptance
of the currency. Our Asian trading partners, needing dollars
to finance their own economic growth, find it convenient to
ignore the risks of dollar devaluation.However, Fed officials
seem to be siding with Mr. Mazhaiskov.

George McTeer, outgoing president of the Dallas Fed, said
on Oct. 8, 2004:"Theoretically, someday ... the flows will
turn against us and there will be a crisis that will result in
rapidly rising interest rates and a rapidly depreciating

This is quite a statement from a regional Fed president. It
is amazing that it was all but ignored in the press.

What is a dollar worth?

It is too bad that there is no obvious answer. As we
have seen, many thoughtful observers have suggested,
and very persuasively, that it is overvalued and that
this overvaluation is unsustainable. Some counter that
the dollar's value in terms of alternative currencies has
been fairly stable, but closer examination of the yen
and euro leads to troubling questions as to their
intrinsic worth. In a world of fiat currencies with no
objective basis for value, the potential for economic
misjudgments seems limitless.

The value of one single, solitary U.S. dollar is
impossible to determine. Purchasing power parity,
exchange rate versus other currencies, and
purchasing power as defined by the Consumer Price
Index do not hold the answer. All three benchmarks
are flawed.These valuation measures are subject to
tinkering by governments to suit their policy aims.
We have suggested as much in "The Real Value of a
Dollar" (Feb. 14, 2004), as have many others:

"In the absence of a gold standard, there is no way to
protect savings from confiscation through inflation.
There is no safe store of value.If there were, the
government would have to make its holding illegal, as
was done in the case of gold."("Gold and Economic
Freedom" by Alan Greenspan, 1966.)

The inability of players in the economic realm to judge
the value of the unit of exchange categorically leads
to mistakes and imbalances that must be rectified in
due course.Fundamental analysis of return on
investment, whether for family savings or corporate
spending, is meaningless in the absence of an
objective and fixed unit value of return, or numeraire.

Economist David Ricardo reasoned that a fixed and
objective unit of account was essential if "one wish(ed)
to make interlocal or intertemporal comparisons (in
the) problem of measuring value." For multinational
producers of goods in China destined for the United
States, a critical factor governing the return on capital,
which cannot be known today, is the future exchange
rate, which dictates the number of dollars returned for
a product sold. While there is always exchange rate
risk in cross-border trade, the risk would seem
especially pronounced in the case of China, which
seems to be the universal justification for almost any
investment proposition.