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Part 2: John Hathaway, ''Beardsley Ruml''s Road to Ruin''

Section: Daily Dispatches

Imbalances must proliferate on artificial suppositions.
Asset values are marked to market in the absence of
an objective standard of value. Credit is extended on
the same false pretenses.Returns are illusory; the
security of credits a fiction. It is the sort of thing that
can happen, unchecked, only in a regime of central

The misdirection of capital flows in the current global
economy is illustrated by the U.S. trade deficit, the
U.S. budget deficit, the 46 percent holding of U.S.
treasuries by foreign investors, the lack any credible
attempt to deal with future entitlement claims, the
pattern of aberrant behavior in housing finance and the
resulting bubble in housing prices, the disconnect
between shrinking bond yields and rising commodity
prices, negative real interest rates, the overweighting
of financial stocks in the Samp;P 500 (20.1 percent), the
bloated 38 percent share of total after tax-profits
generated by financial firms, multi-year interest-free
new car loans, the reckless pursuit of yield in the junk
bond market, the continued overvaluation of equity
markets, the inundation of the hedge fund sector by
capital flows desperately seeking returns,
overutilization of convergence strategies, the paucity
of returns for investment strategies across the board,
the buildup in corporate cash, the excessive
indebtedness of the American consumer, and the glut
of golf courses, casinos, and SUVs. This is only the
short list.

The Treasury Department reported on Oct. 18, 2004,
that net monthly capital inflows from the rest of the
world declined for the sixth time this year.The 50
percent decline in net private investment from a year
ago was more than offset by a rise in Asian central
bank buying.Few would disagree that the obvious
support of the dollar by foreign central banks has a
finite life.These are bad signs for the currency, but
the financial markets appear to exhibit little concern.

The chart below shows that foreign private entities
have drastically reduced their purchases of U.S.
paper and that central banks have more than taken
up the slack.Private companies and investors, not
constrained by policy objectives, are turning in their
dollars to their central bankers in exchange for local
currency. Once they held onto the marginal dollar for
its appreciation potential. Foreign central banks, on
the other hand, are dutifully fighting the market to
keep their currencies undervalued to the dollar.

[Chart at]

How will the exit of the dollar play out? There are
thoughtful arguments on both sides of the issue of
deflation versus inflation. A serious erosion of the
dollar's international exchange value will force the
United States to become self-financing. Our trading
partners do not need to reject the dollar outright but
merely to reduce their buying on the margin as has
been the case over the last several months.As of
this writing the trade-weighted dollar is at the low end
of its range of three years. The dollar has been
against the ropes before and has managed to rally.
It will probably rally again, but within the context of a
well-established downtrend. Aside from a countertrend
rally, a probe to new lows would trigger higher interest
rates, lower equity market valuations, and higher inflation,
as the president of the Dallas Fed has observed.

Dollar weakness could prove stimulative to the economy
in the short run as our hollowed-out industrial base is
called upon to produce what we can no longer afford to
buy abroad. Corporate earnings might rise sharply amid
a contraction of valuations.In short, this would be
something of a replay of the stagflation of the 1970s
triggered by the unwillingness of foreign bankers to
finance our deficits in 1971 and again in 1979 in the
absence of interest rate and exchange rate

The difference between the 1970s and today is that
the magnitude and proportion of our foreign
indebtedness is far greater.

The all-too-popular bearish view of the dollar deserves
a contrarian response.

The deflationist camp notes that there is global
overcapacity owing to direct investment driven by the
well-known arbitrage of labor rates between Asia and
the developed economies. Wages and prices are
capped as long as our Asian trading partners choose
to finance our debt at current exchange rates. The
misallocation of capital on a grand scale has been
financed by a buildup of debt on an even grander scale.

The debt position functions as a synthetic short against
the dollar, which will drive up its international exchange
value as business returns falter because excess
capacity drives prices lower and forces widespread
repayment of dollar-denominated debt. A flight to safety
results in miniscule government bond yields, exploding
credit spreads, and imploding capital markets.

Beware that the preponderance of bearish opinion on the
dollar at this moment could signal a conviction-shattering
rally. The obvious peril to the dollar may have been
sufficiently discounted for the moment, or may still be too
distant to preclude a fake-out countermove.

To many, the possibility of a rising gold price in a
deflationary setting is unlikely. For example, in a recent
article titled quot;Gold is not Signaling Inflation or Deflation
Yetquot; published Oct. 18 by Bianco Research LLC, the writer

quot;Gold's nominal price changes are a function of the
relationship between the expected rate of inflation and the
short-term interest rate costs of carrying inventory, plus
or minus changes in the supply/demand balance.quot;

The accompanying chart in the article goes back only
to 1997.This sort of thinking equates the symptom of a
general fall in the level of prices with deflation but
overlooks the root causes and dynamics of a
deflationary meltdown.It is easy to think that if all
commodity prices are falling, then gold must also. The
article later states:quot;If the price of gold starts to fall
more rapidly than the dollar index increases, deflationary
pressures exist and an appropriate policy response is

The direction of the general price level cannot be
confused as inflation or deflation of credit.Secular credit
cycles are beyond the control of central bankers, although
central banks can certainly augment the process of credit
expansion if they are already under way.A general fall in
prices can occur quite normally during a period of economic
growth that is not deflationary. However, falling prices in a
deflation are only a side-effect of a general paralysis of

The more telling symptoms are very low nominal interest
rates, high real interest rates, and failing household and
corporate credits. Investor behavior shifts from risk taking
to risk avoidance.

In a secular credit contraction, such as we are in the midst
of at the moment, the gold price rises as a measure of the
demand for safety.Central bank attempts to counter the
contraction take the form of excessive paper issuance,
which for a time can inflate asset values due to surplus
liquidity.Ultimately, the market sees these actions for what
they are, monetary debasement. While nominal price levels
may rise in response, as in the 1970s, economic activity

In our view, both inflationary and deflationary scenarios
explain how and why the gold price will rise, not only in
dollars but in all currencies.The dollar's predicament
allows for more than one plausible outcome. Our contrarian
instincts at first guide us toward the deflationary camp,
since it seems under-represented in discussions of this
sort.But the deflationary camp omits an important
consideration, which in our view makes a precise repeat
of the 1930s impossible.

That factor is best summed up in the notion of Beardsley
Ruml: Sophisticated central bankers and enlightened
government policies can always create desirable
outcomes.Disrespect for market outcomes is not
limited to central bankers and policy makers.It is integral
to the post-World War II social compact.Dollar trashing
therefore exists not only as a notional last resort for
desperate policy makers, but also constitutes an option
that would be widely applauded.

According to Bob Hoye of Chartworks:

quot;The purpose of sound money has always been to
'manage' the ambitions of the state. ... In 1900, all levels
of government were taking only 10 percent of GDP and
the public was skeptical about big government. In the last
part of the 20th century, the government take was
approaching 50 percent and the public had visions of
government as a wish machine.quot; (Address to the Committee
for Monetary Research and Education, October 2004.)

Acceptance of the dollar as the global reserve currency is on
thin ice. As with any overvalued security, there is no margin
for anything less than perfection. In the instance of the dollar,
perfection may be defined as uninterrupted and unthreatened
economic growth, consensus belief in the same, low reported
inflation, stable financial markets, political tranquility, and a
restoration of international harmony.

... Misguided Faith

What is the explanation for the persistence of investment
confidence in the face of transparent danger to the status
quo implied in dollar devaluation?

Possible answers include wishful thinking, ignorance, habit,
selective inputs, or a combination. Another possibility is that
there is nothing to worry about at all. The five-year rise in the
price of gold can be taken as a warning or it can be
dismissed. A benign interpretation, non-threatening and
consistent with investment complacency, is that the rise is
based strictly on commodity related supply and demand
factors. It can be argued that gold's dollar price has
underperformed other commodities, especially oil. In
deflated dollar terms, today's $400 handle is only $200
in 1980 terms.In 1980 it peaked over $800, or $1,600 in
today's money.Gold is simply tagging along in the
slipstream of oil, copper, and nickel.

The complacent world view holds that financial assets
will normally generate positive returns, that the dollar
doesn't matter, that the economy is now and always
can be wisely managed, and that in old age, sickness,
and travail there will always be a government backstop
for individuals, businesses, and investors. That view
appears to be widely shared in financial markets.

The notion that the dollar and financial assets in general
are in the early stages of a multi-year decline is alien
and inconceivable. If it were otherwise, the dollar price
of gold would not be $400. It would have at least three
zeros before the decimal point.

When does reality sink in?

Past behavior of the financial markets suggest that the
lags are considerable. Timing markets is hazardous.

Let the tape do the talking, as price is always the best
educator. A visitor from another planet might hypothesize
that investment thinking broadly anticipates financial
markets. Reality is quite the opposite.The explanation lies
in crowd psychology and human behavior, not rational

quot;The sense of security more frequently springs from habit
than from conviction, and for this reason it often subsists
after such a change in the conditions as might have been
expected to suggest alarm. The lapse of time during which
a given event has not happened is, in this logic of habit,
constantly alleged as a reason why the event should never
happen, even when the lapse of time is precisely the
added condition which makes the event imminent.quot; (From
quot;Silas Marnerquot; by George Eliot, as quoted by David
Richards in Barrons, Sept. 20, 2004.)

We conclude with ardent conviction, the more so for our
isolation, that the dollar's role as the global reserve
currency has run its course.The transition to a new
basis for international credit will be lengthy and

The repercussions of a transition are not reflected in the
financial markets.For this reason, gold is inadequately
priced. The best strategy, under these circumstances,
is to own as much as possible of what so few have in
their possession, physical gold. While gold mining shares
will perform well along the way (and should certainly be
owned), they are much easier to manufacture than the
metal is to extract. The same is true for derivatives, or
paper gold.

A private banker recently told us how he had protected
his clients with gold-indexed notes issued by his
employer, and that this practice was widespread in his
department. We hear similar stories from Asian and
European investors.

No institution contemplating gold in four digits would
issue such paper.

It is difficult to understand how a fiduciary, charged with
a responsibility to protect the purchasing power of
beneficiaries, not for tomorrow or next year, but for
generations, could avoid inclusion of this asset class. At
the very least it should appeal to the growing numbers of
TIPS investors -- Pimco for example -- who have come to
distrust the CPI as a measure of inflation.

Any asset allocation analysis that does not incorporate
gold, or that lumps it together with other commodities,
is pointless.Since 1990 the correlation between oil and
gold has been .108, according to our trusty Bloomberg.
The correlation between copper and gold has been
stronger at .738. On the other hand, gold showed virtually
no correlation with the Samp;P (.039) or the trade-weighted
dollar (-.185), while oil correlated in a moderately positive
way (.311) and (.279) and copper in a strongly negative
way (-.575) and (-.687).What does all this mean?

Absolutely nothing. The Bloomberg data covers only a
15-year span of moderate inflation, a statistically
insignificant blip in the context of financial market
history.Data from 1930, not captured by Bloomberg,
would show that financial assets and commodities were
highly correlated, since both imploded against soaring
gold prices.

When will the bull market in gold, still in stealth mode,
run its course? The first step would be a recognition,
on the part of the financial media, that a bull market
has been in place for some time. The second step
would be for the same providers of financial
misinformation to predict more of the same and explain

Still, much more than a supportive financial media would
be necessary to declare that the bullish run in hard
assets is history. The essential component of a secular
top for gold would be an equivalent low in financial assets.

Such lows over the past 100 years coincided with the
culmination of a financial crisis eliciting extreme response
from the government. In those instances, investor
expectations were crushed and remained so for several

In 1934 the Roosevelt administration increased the gold
price to $35 per ounce, an overnight rise of 69.3 percent,
the compensation required to persuade private owners to
part with the metal.From 1980-1982 the Volcker Fed
increased nominal interest rates to double digits and
produced a recession, a feat of political willpower that
seems unlikely to be matched for several years.

With the Samp;P 500 trading at 19 times trailing earnings
and yielding 1.7 percent, optimism reigns. For the
government and its policymakers of all party persuasions,
it is business as usual.

It is not necessary or possible to know the headlines that
will accompany the onset of a winter in the financial
markets.The passage of seasons is ordained in all things,
Beardsley Ruml and his co-visionaries notwithstanding.The
peak in the current gold bull market will coincide with the
end of the road for elitist social engineering, the government
wish machine, and the hoax of unlimited dollar issuance.


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