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James Turk: Dollar has broken down out of its recent trading range

Section: Daily Dispatches

History Repeating

By Marc Faber
Tuesday, October 19, 2004

Investors should never forget the lessons of the South
Sea Bubble and John Law's experiment with paper
money, as discussed in Friday's Reckoning. The
Mississippi Scheme in particular is relevant to the
current situation in the United States; in fact, there
are several lessons contemporary investors can
learn from John Law's rise and ultimate demise.

It is true that Law's policies were initially a great
success, boosting the French economy considerably.
In fact, at his peak in 1719, Law was one of the most
admired personalities in continental Europe. But the
Mississippi Scheme failed, and Law fell from grace
because the Banque Royale held for too long the firm
belief that it could solve every problem simply by
increasing the supply of paper money. When Law
finally realized that the enemy was a loss in
confidence in paper money and accelerating inflation,
the damage had already been done.

There will surely be a time when the present "chain
letter" type of fiat money operation practiced by the
U.S. Federal Reserve Board will similarly no longer
work and lead to a sharp depreciation of the U.S.
dollar. The other possibility, of course, is that the
dollar begins to depreciate, not compared to foreign
currencies, but -- as was also the case at the time
of John Law -- against commodities and real assets.

In my article "The South Sea Bubble and Law's
Mississippi Scheme" --

-- we look at how the excessive money supply
creation by the Banque Royale led to soaring
prices for commodities and real estate as the
French public realized that the banknotes were
depreciating in value.

Concerning real estate, it is very common for prices
to continue to rise for some time after a stock
market bubble has burst, for two reasons. Once
speculators realize that stocks have hit a peak,
they shift their funds to another object of
speculation. In other words, when the world is
engulfed in a wave of speculation, the wave doesn't
end abruptly, but tends to carry on for a while and
spreads to assets other than equities, such as real
estate, commodities, art, etc.

Furthermore, toward the end of a speculative stock
market bubble, the smart investors and (especially
in the case of the recent high-tech bubble) corporate
insiders realize that prices have shot up too much
and bear little resemblance to the underlying
fundamentals. Therefore, they shift and diversify part
or all of their funds into assets that didn't participate
in the whirlwind of speculation and are consequently
absolutely, or at least relatively, "cheap."

Thus, real estate prices continued to rise in Japan
throughout 1990, for example, although the stock
market had already topped out on Dec. 29, 1989.
And in the case of Australia, real estate prices
continued to rise for another two years after its
stock market peaked out in the summer of 1987.

Although real estate prices can stay strong for
some time after a bubble bursts, as money shifts
from liquid assets into real assets, in due course,
some kind of a bubble also occurs in real estate,
because the property market becomes -- in the
absence of a strong stock market -- the only game
in town. As a result, real estate prices eventually
also succumb to the forces of demand and supply
and then follow the declining trend of equity prices.

The Mississippi Scheme and the South Sea Bubble
are also interesting from another point of view. The
wave of speculation in the period of 1717-1720
spread across the entire European continent, and
the subsequent crisis was international in scope.
The initial success of the Mississippi Company
attracted investors from Britain to Paris, where
they speculated in the company's shares. At the
same time, many investors from the continent
also bought shares in the South Sea Company
and other hot new issues in London.

In early 1720, a bizarre reallocation of assets
seems to have taken place among international
investors. As we have seen, the shares of the
Mississippi Company began to collapse in January
1720, but in London, the shares of the South Sea
Company had only begun to take off. In other
words, British and international investors were in
no way perturbed by the collapse of Law's scheme.
In fact, in London, the view was that the scheme
had collapsed because of a political conspiracy
against Law, since he was of Scottish origin.

However, in the summer of 1720, just as the South
Sea stock peaked out, speculators moved funds
from England to Holland and Hamburg in order to
speculate on continental European insurance
companies. I mention this because once excess
liquidity has been created, money will flow from
one sector or country to another very quickly and
can lead to a series of new bubbles somewhere

For today's investor, however, the most interesting
effect of excess liquidity creation is perhaps found
in commodity prices. In the future, just as during
the Mississippi Scheme, a bull market in
commodities is a distinct possibility and could
exceed investors' expectations. I have no doubt
that the Federal Reserve Board will continue to
flush the economy with liquidity, which at some
point could spill over considerably into the
commodities markets, as it did during the
Mississippi Scheme, and also in the late 1960s,
which led to a sharp rise in the price of commodities
and real assets.

In particular, I want to emphasize that commodity
prices can increase sharply under any economic
scenario, provided that there is excessive money
and credit creation and that investors' confidence
in financial assets is shaken. Take the early 1970s,
when commodity prices soared, even as the global
economy headed for the worst recession since the
1930s. Even more impressive than the rise in the
CRB Index was the performance of agricultural
commodity prices. From their lows in 1968-69 to
their highs in 1973-74, wheat rose by 465 percent,
soybean oil by 638 percent, cotton by 317 percent,
corn by 295 percent, and sugar by 1,290 percent.

Or take the deflationary Depression years of the
1930s. At the time, the price of silver had been in
a bear market since 1919, but made a first bottom
at 25.75 cents on Feb. 16, 1931, and a marginal
new low on Dec. 29, 1932, at 24.25 cents. From
there, however, silver prices advanced to 81 cents
in 1935, for a gain of more than three times their
lows. In addition, if an investor bought silver in
1929 instead of the Dow Jones, which was then
above 300, by 1980, when silver hit $50, he would
have realized a profit of close to 200 times,
whereas by 1980, the Dow was up by less than
three times its 1929 peak.

The most dramatic commodity bull markets all
originated after extended bear markets, such as
we have had since 1980 and which accelerated
on the downside following the Asian crisis and
again in 2001, when it became clear that the
global economy was in trouble. At issue is the
fact that off their lows -- whenever these lows
occurred -- commodity prices experienced
dramatic upward moves within brief periods.

If the global economy doesn't improve dramatically,
it is likely that commodity prices will be boosted,
because of further liquidity injections by the
monetary authorities as well as expansionary
fiscal policies. Moreover, if the U.S. economy and
the investment climate for financial assets in the
United States don't improve, it is likely that the
U.S. dollar will weaken even more.

Now consider this: Investors have little faith in
either the euro or the yen. Therefore, if in the future
international investors lose confidence in U.S. dollar
assets, where will they go with their liquidity?

Take as an example the Asian central banks whose
assets are concentrated in U.S. dollars and who
only hold about 3 percent of their reserves in gold
(down from 30 percent in 1980). If the day should
come when their faith in the U.S. dollar is shaken,
will they pile into euros or the yen? Possibly, but it
is also conceivable that, given the less-than-stellar
fundamentals for these currencies, a diversification
into gold will be considered.

As a holder of gold shares and physical gold myself,
I sincerely hope that there will be genuine deflation
in the domestic price level in the United States. In
this case, the economic mess will be complete, as
the default rate among corporate borrowers will soar.
At the same time, the confidence and blind faith of
investors in the omnipotence of Mr. Greenspan will
finally collapse and lead to a panic. That in such
an environment gold prices could go through the roof
isn't difficult to envision.

With or without inflation, investors should therefore
continue to accumulate gold and silver shares and
a basket of commodity futures.


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