Why gold?

The Market Oracle yesterday and Gold Seek today both feature an article by Michael Kosares from his own site (USA Gold) on why he thinks you should own gold.

One reason is the fecklessness of the US Government:

"...the national debt stands at $8.9 trillion - nearly $30,000 for every man, woman and child in the United States. And there appears to be no end in sight to the fiscal madness. The debt clock ticks non-stop at the rate of about $1.3 billion per day.

I should point out that there is a difference between the "deficit" and "additions to the national debt." The deficit often quoted by politicians and the mainstream press is discounted by borrowings from the social security fund - a machination meant to dilute the real budget deficit which is the actual addition to the national debt."

I only knew recently about this business of putting their hands in the social security till and leaving an IOU. That is disturbing, because of the desperation it implies. Wasn't it the financial cost of the First World War that led to the raid on British social security funds and the switch to a rob-Peter-to-pay-Paul system?

Kosares starts his article with two quotes (I've added the sources):

"[U]nder the placid surface there are disturbing trends: huge imbalances, disequilibria, risks -- call them what you will. Altogether the circumstances seem to me as dangerous and intractable as any I can remember, and I can remember quite a lot. What really concerns me is that there seems to be so little willingness or capacity to do much about it. . . We are skating on thin ice." - Paul Volcker, Former Chairman of the Federal Reserve (Washington Post, 10 April 2005)

"[W]e live in a globalized environment and in a country which has enormous fiscal and external deficits. So you have to figure out some way -- which I have not done I might add -- to protect yourself if we should have a real currency problem here." - Robert Rubin, Former Treasury Secretary (interview with Kim Schoenholtz, Citigroup New York, 10 October 2006)

He discusses 6 trends: the US National Debt, the trade deficit, dropping real rates of investment return, derivatives, debt to foreigners, the US dollar's decline.

The conclusion, obviously, is that in times of doubt and distrust, gold will act as a haven for real wealth, as it has done in the past. "Price appreciation... is a sidebar to gold ownership. The main story is gold's asset preservation qualities."

More on Brad Setser

Further to the last, it's worth struggling through Brad Setser's presentation to the Congressional committee even if (like me) you're not an economics buff.

In essence, he says that America has gotten away with its continuing trade deficit over the last few years, for several reasons:

• the effective interest rate on foreign debt held by the US, is higher than on loans made by foreigners to America


• foreign equities have had higher yields and better capital appreciation, so US overseas investment has done better than foreigners' share holdings in America


• the weakening dollar has amplified the effects in both points above


• foreign central banks' willingness to buy US debt has kept US interest rates low, making Americans' debts easy to service and fuelling share and property booms

But it can't go on for ever. Either America's debts will continue to increase, or foreign sovereign wealth funds will buy more and more equities, or both. If foreigners slacken in their support for US debt, interest rates will rise; and losing equities to foreign owners takes away from America's future wealth and income.

Setser concludes:

The US will likely both have to sell more equity to the rest of the world and pay a somewhat higher interest rate on its external debt than it has recently...

While rapid central bank reserve growth and large official financing of the US deficit can help the US postpone the necessary adjustment, the longer the adjustment is deferred, the greater the long-term risks...

Bringing the US deficit and emerging economy surpluses down without tremendous costs will also take time. If the US and the world are to adjust gradually, they need to get started.

Yet again, I wonder whether the UK's enormous purchases of US dollar-denominated securities since June 2006 make sense for Britain.

Another thought: seeing two late market interventions last week, Dan Denning in The Daily Reckoning Australia (3 August) speculated that there may be "...in the financial market a buyer of last resort who comes in to goose the indexes at critical times, when investor confidence is especially fragile."

Rather than the Plunge Protection Team, could it be foreign sovereign wealth funds buying-in on the dips? Maybe that's why the Dow has bounced back 286 points today, as I write.

China close to owning $1 trillion of US assets

This graph is from evidence given by Brad Setser (of Roubini Global Economics) to Congress on June 26. His presentation was on US debt to foreigners and the economic vulnerability that it implies. The full PDF document can be found here.

Noriel Roubini himself theorises that the US is approaching a Minsky turning point - i.e. a credit crunch - as reported in FXStreet last Friday.

Which US Presidential candidate is the best hope for the American economy?

Looking at the current field for the 2008 US Presidential race (and trying to set aside other important issues), which candidate's economic ideas make the most sense for America? Unless the questions are asked, they won't come high on the agenda.

I have tried to use Blogger's new poll facility, which allows for more than one answer, but there's a glitch at the moment, so it's a one-shot question for now.

Your comments on the candidates, their ideas and the issues are welcomed.

An alternative reserve currency?

As America's balance of trade continues to weaken it, and the dollar's value erodes, the question arises, what could replace the greenback as the world's trading currency?

Assuming that gold reserves are relevant to trust in the currency, it's interesting to note that Germany has almost half as much as the US, and its balance of trade is not so unhealthy. Interesting also that the German mark, although currently in a fixed exchange rate with the Euro, still has a nominally separate existence.

Julian Phillips (GoldForecaster.com) says in his 29 June article, "Germany is aware that the times they are a-changing, and so it is keeping one eye on the future of the global economic and monetary order – and guarding against it."

Here are the four greatest world holdings of gold (June '07 World Gold Council figures):

United States 8,133.5 tonnes
Germany 3,422.5 tonnes
IMF 3,217.3 tonnes
France 2,680.6 tonnes

France has a negative balance of trade, and has reduced its gold hoard by around 11% since 2000, but nevertheless, between them the last three on the list above have gold reserves totalling 14.5% more than the US. Politically, France and Germany are the Western core of the EU. If things change radically, who knows what the new world order may look like?

The gold question

Here's a couple of articles by Julian D. W. Phillips at GoldForecaster.com. They're extracts and the entire text is only available if you subscribe to the site.

But because they are freebies, and have much interesting and relevant information, I reproduce the extracts here. The first is a response to the recent sale of some gold reserves by Switzerland. It appeared in BullionVault on June 29:

WITH THE Swiss central bank selling 250 tonnes of its gold reserves, the classic question has to be asked again, what is the price of gold? If we answer that it's worth a certain number of Dollars, then we have to ask the next question:

Just what is the price of a Dollar?

Is the US Dollar such a reliable a store of value that it can be used as a measure of gold's value? To ask would be to question the very foundation of the paper currency system. Can one trust the Dollar or even the international monetary system? It’s all a question of degree.

The US government itself holds mainly gold in its reserves, because it is the issuer of the world’s reserve currency. This does imply that it is completely dependent on its own currency, the Dollar, in the global economy. As the foundation of the world’s monetary system, should this currency lose the confidence of its own or other nation’s citizens, the international money system – and trade relations across the world – will be damaged severely. It is thought that this process is well under way.

The Eurozone community’s Central Bank drew off 15% of its reserves in gold from its members. This does not mean it intends to only hold 15% of its reserves in gold, nor does it imply that there is a rigid exchange rate between gold & the Euro. But the question of how to measure 15% of reserves is raised.

From the beginning of the Central Bank Gold Agreement, the European Central Bank decided to sell a fixed tonnage of 235 tonnes of the reserves it inherited from its member banks in return for paper currencies. Ostensibly, this was to keep gold's proportion in the ECB's reserves roughly fixed. The ECB is fully aware of the dangers of measuring gold in the Dollar – and in the Euro for that matter – but for the sound functioning of our paper-currency world, it is crucial that gold be subject to measurements in paper currency terms, and not the other way around.

With gold now higher from seven years ago, bullion is now around 25% of the ECB's reserves. Perhaps that's a level the Frankfurt policymakers prefer?

Germany, who gained the right to sell up to 500 tonnes of its gold under the CBGA, has not taken this option yet, citing that “gold is a useful counter to the swings in the Dollar.” Of course, a doubling in the price of gold since making this decision is paying off handsomely. We commend the pragmatism of the German Bundesbank; its reserves are there for a rainy day. They are not a pension fund scheme requiring profitable investment.

Certainly, growing a nation's reserves through investment and trading can be a secondary objective, but it should never take over first place. The reserves have to be credible in times of distress, and they have to acceptable to all trading partners.

Germany is aware that the times they are a-changing, and so it is keeping one eye on the future of the global economic and monetary order – and guarding against it.

Italy has no plans to sell any gold, which is unsurprising given the very poor history of the Italian Lira. They too have seen several currencies come and go in the last one hundred years, so they have few illusions about the joys of compound interest. After all, adding noughts to a currency doesn’t make it more valuable. It’s only the buying power that counts.

So will the Dollar today, with interest added over the next decade or two, be worth more than today’s equivalent in gold in a decade or two?

The Swiss Franc has always been one of the most stable of the globe’s currencies, based upon one of the most stable and constant of economies. In times of global war or uncertainty, this peaceful anti-war country becomes itself a ‘safe haven’ for foreigner’s savings. So it is almost a source of safe money and financial security in itself.

The Swiss concept of a rainy day contains far less moisture than most other countries fear. Switzerland is therefore financially more secure and less dependent on its reserves than other countries, whilst also being small enough to adjust its reserve holdings within the foreign exchange markets capacities at present. With the mix of gold and currencies in the Swiss National Bank's portfolio, you can be sure they have covered their backs on the risk front and stand to gain either way the cookie crumbles.

It is of little account whether the Swiss sell some more gold or not. We see their latest move – announcing the sale of 250 tonnes by 2009 – as a gesture of support for the paper currency system. The SNB no doubt sees it as a gesture to protect its overall reserves portfolio.

Again a key question: Why sell gold at all – or more pertinently, why sell a little gold and retain sufficient for rainy days ahead? It is to ensure the retention of value in the overall portfolio. The SNB is not the getting rid of the gold content therein.

Clearly Switzerland – with its constantly sound position as banker to the wealthy of Europe, alongside its dependence on the banking industry – has a vested interest in a mix of global paper currencies. It retains a greater vested interest than those nations with an unsound Balance of Payments, smaller reserves, and facing greater economic risks in the global economy. Besides the United States, nations now suffering a poor balance of payments include Australia, New Zealand, Britain, France, Italy, Greece, Spain, Czech Republic, Poland, India, Pakistan, Colombia, Mexico, Hungary, Turkey, South Africa and many others.

The big question: will gold have a greater real value in times of distress than yield earning national currencies? In the last world war, what value did the Deutschmark – or indeed the US Dollar –have internationally? Remember, forgery is one of the acceptable weapons of war. And what value did gold have? No contest.

With economic power shifting Eastwards, and the Asian nations growing away from their dependence on the US economy, it is inevitable that reserve currency dependence such as we are used to with the Dollar is now changing. It is fragmenting, with other currencies coming onto the scene and with national interests clashing and exerting pressure on the different leading world currencies.

Should these pressures grow beyond a certain almost indefinable point, then paper currencies will not garner the same level of confidence as they do now, and the unquestionable international reliability of gold as a measure of value will ascend further still.

Prime Minister Brown of the UK went the same way that Switzerland is, once again, going to go. Looking for a more profitable content to the UK’s gold and foreign exchange reserves in 1999, the UK paid a heavy price that continues to grow as the gold price rises. Did Brown act for political reasons in support of the Euro and the more controllable paper currency system? We believe Switzerland may be following the same line of reasoning as Brown did then.

After all, if we measured the proceeds achieved from the last sale – and the total value plus the interest thereon – what would the shortfall be against today’s value of gold?

The mix of foreign exchange and gold reserves is essentially a gamble on the future.

The second is issued today on GoldSeek:

As the move to keeping what nations have already Protectionism is in full swing. This will inevitably disturb the currency world, who quite rightly will look to something that will protect them from the rising volatility in the currency markets alongside seeping confidence from the U.S $. This ‘something’ will include gold and gold investments. Both Protectionism and Capital Controls will enter the scene as this happens as testified to by history.

Will the States do such a thing? Of course it would. The games played to prevent China acquiring U.S. oil companies with reserves in Central Asia demonstrated this aptly, last year. U.S. patriotism will ensure this happens wherever it is obvious. The necessary legislation is in position already, albeit in a seemingly unrelated form. It is always hard for Politicians to pass unpopular or freedom-inhibiting measures, so they are best attached to causes that persuade individuals and Congress to accept such limitations, such as the recent powers over troublesome individuals in Iraq. This paves the way for full control over financial markets of all types. Here is an example of how a popular cause can be used in this way from the White House itself.

“Pursuant to the International Emergency Economic Powers Act, as amended (50 U.S.C. 1701 et seq.)(IEEPA), I hereby report that I have issued an Executive Order blocking property of persons determined to have committed, or to pose a significant risk of committing, an act or acts of violence that have the purpose or effect of threatening the peace or stability of Iraq or the Government of Iraq or undermining efforts to promote economic reconstruction and political reform in Iraq or to provide humanitarian assistance to the Iraqi people……….. In these previous Executive Orders, I ordered various measures to address the unusual and extraordinary threat to the national security and foreign policy of the United States posed by obstacles to the orderly reconstruction of Iraq, the restoration and maintenance of peace and security in that country, and the development of political, administrative, and economic institutions in Iraq.

My new order takes additional steps…………by blocking the property and interests in property of persons determined by the Secretary of the Treasury, in consultation with the Secretary of State and the Secretary of Defense, to have committed, or to pose a significant risk of committing……… The order further authorizes the Secretary of the Treasury, in consultation with the Secretary of State and the Secretary of Defense, to designate for blocking those persons determined to have materially assisted, sponsored, or provided financial, material, logistical, or technical support for.

I delegated to the Secretary of the Treasury, in consultation with the Secretary of State and the Secretary of Defense, the authority to take such actions, including the promulgation of rules and regulations, and to employ all powers granted to the President by IEEPA as may be necessary to carry out the purposes of my order. - “ GEORGE W. BUSH “

Such moves seem reasonable in this case. Our reason for the inclusion of this quote is to clarify just how quick and easy it is to impose restrictions on the spending of the U.S. $ in the hands of any person, institution or nation, not acceptable to the U.S. Administration, [whether he be a foreign national or a U.S. citizen, just as it is in any other nation’s hands [Whether it be Germany, or China itself or any other nation – this is the power a politician has always].

Capital Controls

In all the historic instances of either Protectionism or Capital Controls, but in particular Capital Controls, such measures were and can be imposed overnight and became an instant unchangeable reality. Protectionism appeared to be the most reasonable and less dramatic but produces softer but similar consequences in each case. Applied globally [and nations hit, usually respond by imposing their own protectionist measures] they rupture the smooth flowing of trade and finance.

Capital Controls are more draconian than Protectionism however broadly spread, causing huge swings in currency values, so are halted as quickly as possible so as not to damage what is left of a nation’s economy. However, in the case of Britain, where a dual currency system was instituted it stayed for a couple of years. In South Africa where Exchange Controls have been present for more than 30 years now, the Capital Control component lasted for around 20 of these years. In both cases a main component of these controls covered investments of all kinds, loans and any transaction of a Capital nature. In both cases the “discount” on the value of the sales of shares for the repatriation of Capital reached 30%.

Bear in mind that as far as we can see ahead Asian and other nations’ surpluses will continue to burgeon. As they become so bloated that they pose a threat to the $ by the sheer risk of their movement from the U.S. Consequently the possibility of even a partial exit of foreign nation’s surpluses from the $ becomes almost inevitable. So, the nation will, at some point, just have to impose Capital Controls, if only over the removal of foreign nation’s surpluses from the Treasury market.

If such Capital Controls were imposed in the U.S., which would be an almost certainty at some point in the future as money floods from the country, the entire global money system would be irreparably damaged and a flight to hard assets [lead by gold, silver and other precious metals] certain. The break in confidence in currencies themselves would be savage.

Much to chew on here.

Out and in

Another quote, this time from Ludwig von Mises (via the Daily Reckoning Australia):

"There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved."

Like any sane person, my preference is the first option.

I have no idea how much longer this expansion will continue, but we've asked to take our modest holdings today. Maybe we'll miss out on a further commodity boom in the next few weeks, though it seems that when the market gets skittish gold runs with the herd for a while. We plan to come back in soon enough, on a regular premium basis; but unless Monday sees a significant drop, we've done all right over the last couple of years. Thank you, Mogambo Guru and others.

Official market intervention?

Interesting quote from today's Daily Reckoning Australia:

Meanwhile, is the Plunge Protection Team (PPT) hard at work in the US? For the second day in a row, Wall Street rallied over 100 points in the last hour of trading.

You can interpret this in one of two ways. First, bulls and bears are earnestly engaged in combat for control of the market. Bears are winning the field for most of the day, with the Bulls rallying late.

The other, more sinister theory is that there exists in the financial market a buyer of last resort who comes in to goose the indexes at critical times, when investor confidence is especially fragile. We take no position on the matter. But it sure does look weird on a chart.

This could be connected up with the UK's surge in US Treasury security purchases over the last year. The conspiracy theory here would then be that the plane is already in trouble, and the stewardesses (I've forgotten the PC term) are walking the aisles to reassure the passengers.

Time to take gains?

Hiding Public Debt

In response to comments from "City Unslicker" (see previous post), a Business Wire article trawled via Highbeam (subscription required) reveals that in the UK, the equivalent of US $98 billion of projects have already been agreed under the Private Finance Initiative.

These are, apparently, also known as BOT (build-operate-transfer) projects. Half are to do with transport, but PFI is also used for schools and hospitals.

From: In the UK, under the Government's "Private Finance Initiative" Launched in 1992, BOT Projects with a Value of GBP 48.3 Billion Had Been Signed by March 2006.
Source: Business Wire, January 15, 2007. Via: HighBeam™ Research; COPYRIGHT 2007 Business Wire

The Independent (June 6) reports on a National Audit Office finding that many PFI projects are poor value. This kind of financing has been controversial for a long time, and seems like another way of burdening future generations while pulling the wool over the eyes of the present electorate. It seems to me like another sign that governments are losing control of our money and trying to pretend they're not. The pretence merely prolongs and increases the problems.

From: Half of PFI deals fail 'good value' test ; Business News IN BRIEF
Source: The Independent - London, June 6, 2007. Via: HighBeam™ Research; Copyright 2007 The Independent - London

...and now a high-profile project in London, servicing the underground railway system, has suffered financial collapse, leaving behind extra costs and political embarrassment:

From: Tube's 17bn upgrade at risk as Metronet collapses ; Mayor will need to find 50m a week by DICK MURRAY
Source: Evening Standard - London, July 18, 2007. Via: HighBeam™ Research; Copyright 2007 Evening Standard - London

Poll update

Early responders seem to prefer gold and silver to foreign currencies, as stores of value. As Shylock correctly pointed out, "thrift is blessing, if men steal it not", and the fear of inflation's theft appears to be greater than the promise of interest on foreign bank accounts. The "breed of barren metal" is winning at the moment.

Please vote in the polls opposite.

Gold stocks heading for a postwar low

I've looked at the World Gold Council's long-term series from 1948 on. Current gold stocks held by governments are at a low not seen since before 1949: WGC figures for June 2007 total 30,374 tonnes (another 9 tonnes down from last December).

In 1948, official world gold reserves weighed 30,182.6 tonnes; in 1949 they were 30,623 tonnes, more than today's holdings. From then on, the hoards increased, reaching a peak in 1966 (38,283.6 tonnes). In 1967, they dropped suddenly to 36,900.9 tonnes.

Then the slow slide, taking these periods to lose around 1,000 tonnes at each stage:

1968 - 1978 (11 years): 36,000 - 37,000 tonnes
1979 - 1992 (14 years): 35,000 - 36,000 tonnes
1993 - 1996 (4 years): 34,000 - 35,000 tonnes
1997 - 2000 (4 years): 33,000 - 34,000 tonnes
2001 - 2002 (2 years): 32,000 - 33,000 tonnes
2003 - 2004 (2 years): 31,000 - 32,000 tonnes
2005 - 2006 (2 years): 30,000 - 31,000 tonnes

You'll see that the rate of loss steepened from 1993 onwards, and accelerated further from 2001. We're now approaching the lowest point since these records began, 59 years ago.

Are gold stocks a measure of world economic progression and regression?

Where's the gold gone?

Looking again at World Gold Council stats, there's something odd: a heck of a lot of gold has disappeared.

In seven years, from the first quarter of 2000 to the last quarter of 2006, the total tonnage held by countries and the IMF and World Bank has declined from 33, 375.1 to 30,383.8. That's a total reduction of nearly 9%, 2,991.3 tonnes of gold to be exact. At today's price ($21,426.87 per kilo), that's $64.09 billion gone off the radar.

Or to put it another way, at this rate of attrition, there will be no officially-held gold in the world at all in about 71 years' time, less than the lifespan of an average American.

The people must be voting in the only way that makes much difference these days, squirreling away pieces of gold. Or does anyone have a better explanation?

Bad news update; listen to Grandad

Peter Schiff has been quoted in various sources, e.g. the LA Times, as predicting oil at $100 a barrel.

Michael Panzner refers us to a site called Grandfather Economic Report, which like me is concerned about the impact of bad economics on families and the next generation.

Money and crime

The Mogambo Guru (Richard Daughty) posts a long one on The Daily Reckoning, including the text of his speech at the recent Agora Financial "Rim of Fire" conference in Vancouver. He writes and speaks like a Ranter from the English Civil War, or a Cassandra who has already dug her secret emergency escape tunnel out the back of Troy, away from the Greek lines.

But underneath the Vincent Price-like, self-parodying Gothic melodrama, I feel he's right. The answer to the question in my previous post is yes, because as money continues to be produced, of course everything will go up in nominal terms, for a time. The turning point will come when people realise that their money is going to be worth noticeably less every month, and trust in the currency will be in danger of collapse.

I also think he's right in saying that this systematic abuse suits the powerful, and their lesser friends and servants. Much of human misery is the result of people's unwillingness to do genuine work, so oarsmen will be replaced by coxes until the crew is entirely composed of steersmen and the boat stops. You do not have to be a member of the National Rifle Association to think that ever-increasing government is a problem.

Where I disagree, is the bit about looking forward to being a complacent gold bug while your neighbours suffer. Not for moral reasons, but from the practical point of view that in such a situation, your life and property would not be safe.

I remember that in the early nineties, when recession was chewing on us in the UK, one hard-working and decent small-businessman client was starting to talk, only half-jokingly, about turning to crime, just to survive. Until then, it had never occurred to me that some "stand-up guys" could be driven that way; I'd always assumed that criminals were simply a type. But I could tell he was getting serious - many a true word is spoken in jest. Fortunately for him and the rest of society, the economy improved, his house increased in value, and he sold up and emigrated to the Far East. I hope it's working out okay for him.

Back here, and in the US, I'd like to see economic reform now, not social breakdown later.

Could the Dow AND gold BOTH go up?

In unusual circumstances, normal behaviour changes, as Richard Bookstaber recently observed. If the dollar's decline continues, and gold maintains its "real" value, a 17% dollar devaluation would mean a corresponding 20.48% increase in the price of gold, carrying the yellow metal over the $800 threshold.

A weaker dollar makes imports more expensive - both finished goods and raw materials - but is a stimulus to some exports. Maybe, if it didn't all happen too suddenly and scare everyone off the market, the Dow would rise.

It would also mean paying back foreigners with cheaper money, a trick played on the world by Britain's Harold Wilson in the devaluation of 19 November 1967, when the pound's foreign exchange value was cut abruptly by 14%.

The US Treasury's figures for May 2007 show there's a total of $2.18 trillion in foreign-held securities. A Brit-style 14% devaluation would lose Uncle Sam's partners about $305 billion. John Bull's share of that loss would be some $23 billion, or around £11.5 billion.

Maybe that would finally get the British news media to notice the recent huge UK support for US government debt. I can hardly wait. Be still, my beating wallet.

There's a political price to pay, but US Presidents can't serve more than two terms anyway, not since they changed the Constitution to stop another Roosevelt reign.

Harold Wilson resigned in 1974, citing ill health, but I did once hear a rumour that the IMF, which bailed us out in 1975, had made Wilson's resignation a precondition of the loan. In these document-shredding and email-deleting times, a paranoid would say you know it's the truth when it's officially denied.

Meanwhile, please place your bets in the two polls opposite!

Good advice

An amusing e-letter from Investment U today. Its strapline is "What no books, no schools, no brokers will teach you".

With good reason, if the content is anything to go by - it seems that all you have to do for a comfortable retirement is invest in stocks that go up like rockets. And it gets better: the best way (it seems) to choose those stocks is to look at how they've done in the past.

The figures are great, too. To create $100k per year in 10 years' time, they say you'll need a fund of $2 million. Apparently there's no such thing as inflation. Because if there is, and it rolls on at a sedate 2.5% compound per year, you'll need 28% more in 10 years' time.

In actuality, assuming you want your retirement income to be inflation-proofed, your fund will have to be not 20 times the planned income you want, but closer to 40. Partly it's because we're living longer (and retiring earlier), but mostly it's because the life insurance companies have cottoned on to the fact that our governments are (a) losing control of our finances and (b) lying heroically to us about it.

So maybe we're aiming at a fund of $5 million.

The rate of return shown is wild - a mere 29.6% per year. One would have to be "in denial" to postulate a steady 30% a year in America's train-wreck economy, when the great Warren Buffett has been sitting on billions in cash for years and has recently started to hedge against the dollar. Doug Casey has something that he says is "going to the moon", but that's gold - a speculation if ever there was one.

Here in the heavily-regulated UK, the maximum pension growth that can legally be illustrated is 9%, but that's including fund management charges. "Stakeholder" pensions have a maximum annual charge of 1%. So let's assume an (optimistic) annual growth rate of 8%.

Using our revised end-point, our legally-restricted growth rate and working backwards, as in the example provided, we need to start with a lump sum of $2,315,967. Not $194,400.

The article does make some serious points:

• baby boomers are facing a retirement crisis (Richard Bookstaber mentioned that in his interview with Jim Puplava, and thinks it'll be one of the drag factors on investments for many years to come)
• longer-term investments can afford to be riskier than short-term investments
• in the long run, we normally expect equities to outperform bonds
• investing earlier reduces the required rate of return to achieve your end-point target, so start early

But please, don't think that returns over the last 5 years are anything to rely on. "The Legg Mason Opportunity Trust (LMOPX), for example, has a 5-year annual return of 20.74%," say these not-your-brokers. The Dow itself has risen 60% since August 2002, but you have to remember where we were then. So Legg Mason's fund has returned an average 10.7% p.a. above the Dow.

How did it do that? Much depends on the type of fund you're in - a fund whose name includes the word "recovery" or "opportunity" is usually one that concentrates on smaller companies, the shy, creeping things that are the first to emerge from the undergrowth after the storm. These are also damaged more easily than the big beasts by economic downturns. So the real lesson is, be in the right type of asset at the right time. Getting into a recovery fund in '02-'04 was a good choice, then.

And how about highlighted stocks? "Starbucks, Franklin Resources, General Dynamics, Amazon, Citigroup… These companies have posted average returns in excess of 30% a year, for more than a decade."

...I'm now reading Benjamin Graham, the man who taught Warren Buffett, and a note to the latest edition points out that in 2000 and 2001, Amazon. com lost 85.8%. If you'd been one of the victims and had to re-start with 14.2 cents for every dollar you had originally, you'd have to post a 704% gain just to get back where you started (and even then, you'd still be behind inflation, and interest earned safely on deposits). The first principle of investing is not to lose your money.

If you're going to risk a fortune on individual stocks, maybe you should blow your wad at the track instead - it'll be more fun. A nice day out, a bit of champagne, and you can sell your binoculars for the fare home.

There's an adage in law: "Free advice is worth what you pay for it". If you want advice, seek out a broker and pay for it. The poor sap is then liable for all your losses, while any gains are down to your wisdom in picking him.

Seriously, though, read financial newsletters with caution, and read the disclaimers first.

Poll: how would you hedge against a dollar fall?

...and for extra marks (especially if you're putting your money on it!), let's see what currency or precious metal looks like the best store of the value of your dollars.

Warren Buffett recently revealed he's hedged against the greenback, and gold and silver bugs are contesting the merits of their respective hoards. If your preference is for currency but you wonder about the backing, remember that Germany has the world's second-largest stock of gold, whereas Switzerland and the UK have been persuaded to get rid of about half their gold holdings since 2000.

Meanwhile, Japan and China are both struggling to hold their currencies down, to protect their export markets. Russia seems keen on claiming half the Polar region and is already able to use its energy supplies as an economic weapon. India is developing fast, and may turn out to be an interesting rival for China.

Here's our starting point today, using the figures from the Currency Converter widget on the sidebar. $1,000 will currently buy:

729.74 Euros
1,427.25 German Marks (there's a glitch in the currency converter, so I've done this in two stages)
119,080 Japanese Yen
7,581.23 Chinese Yuan or Renminbi
492.40 British Pounds
40,383 Indian Rupees
25,548.20 Russian Roubles
1,203.70 Swiss Francs

An ounce of gold costs $665.03
An ounce of silver costs $12.92

Where would you hold your savings until the New Year?

Jim Puplava's interview with Richard Bookstaber

Richard Bookstaber's interview on Financial Sense (21 July - audio file) was interesting. He discussed the derivatives market (which is the subject of his book, "A demon of our own design"), in which he has been intimately involved. It's a long interview and I'll just pick out one or two points.

Derivatives are financial bets. Portfolio managers use them as a kind of insurance, which then means that they can safely (they think!) increase their exposure to equities.

But derivatives are complex, and can have unexpected effects. For example, in October 1987 there was a sizeable drop in the stockmarket, and as the prices went down, automated trading programs noted the crossing of pre-set thresholds and this triggered more selling, which took the market below other programmed thresholds, and so on.

Also, to work properly, the derivatives market needs to be "liquid and efficient". Well, when the major turmoil was happening as just described, people held off buying back in - the scale had scared them. So they weren't doing what the system expected them to do, and this change in behaviour meant that there was less support at certain price levels than the system assumed.

Another way in which the system became inefficient at greatest need, was that certain classes of asset behaved in an untypical fashion. For example, normally bonds move together, and in the opposite direction to equities; but in 1987, when it looked like major disaster, poorer-quality bonds fell as though they were equities (because of fear of their defaulting), whereas Treasury bonds (backed by the government) rose.

I have heard that in times of stress, people make unusual mistakes, such as confusing left and right, and it seems that the derivatives market has similar potential in extreme situations. You can't tell how people will react under great pressure.

Then there's "black swan" events that haven't been factored-in, but can still happen, such as Russia's decision to default on its loans, which very nearly did for Long Term Credit Management and much more besides.

On top of that, there's the question of leverage, i.e. borrowing that greatly increases the risk and returns of an investment. The current debacle re mortgages packaged as interest-yielding investments stems from the fact that not only are the packages leveraged by a factor of 10 or 20 to 1, but the hedge funds that bought them might themselves be leveraged by a factor of 5, so magnifying the basic risk of sub-prime lending by a multiple of 50 or 100. So when things go wrong, they really go wrong. As we now see.

There is also the question of inadequate information about derivatives. The method of accounting was originally developed to track rolling stock for railways, not for super-fast, computer-based trading. The data available may not be what you need to assess the situation properly, and will almost certainly be out of date in the moment-to-moment market changes. Bookstaber thinks we need to use modern technologies to get the right data out of the system fast enough to make sensible decisions.

And in assessing risk, people's memories are too short. Fund managers may be too young to remember really bad times like 1989-91, so run the risk of complacency.

Speaking of age, there's a demographic risk, too: the baby-boomers are coming to the point where they'll want money out for retirement, and maybe the market hasn't fully realised this change in the financial climate. It could be a "slow burn" crisis like the one that hit Japan, lasting maybe 15 or 20 years.

Now, many of these periods of turbulence probably don't impact on the individual investor, says Bookstaber; the private investor should buy and hold, not panic.

However, a systemic risk that could have really serious consequences is the possibility of a major failure in the mortgage and credit markets, which could then roll on to the banking sector.
Yet again, we're back to the banks, credit and the money supply. How ever did we come to think of bankers as responsible people!

Anyhow, listen to the audio file and see if I've represented it fairly. And buy the book if you think it's relevant to your line of work or investment.

Dow survey update

One more day and we'll stop - thanks for your responses. We've seen a little bit of a rally in the last 36 hours and so far (12.35 New York time) the Dow is down 2.55% from its 25 July close. Pessimism is also down a bit - less than two-thirds expect the Dow to be below 13,000 at year end.

Any more votes?

Dow value afterthought

...and if we remember the heady close of December 1999, before tech stocks burst, the Dow was then at 11,497.12. We've had 7 years and 7 months elapse since, with an average growth of just under 2% compound per year. Adjusted for inflation (or available bank deposit interest rates), we've actually fallen behind; or, from a different point of view, we're not so wildly overvalued.

Actually, what I suspect has happened is that the balloon has a tear in it, and has been kept from falling to earth by massive amounts of extra monetary hot air; but "in real terms" we're still stuck somewhere in 1999. In short, we haven't yet faced up to the problems of our economy.

To use a different analogy, we're still drinking, in order to put off the hangover. But maybe there's lots more "booze" left (i.e. the Fed's printing press, aped by the Bank of England and others) and our "livers" (the real economy of production and jobs) will hold out a while longer.

It's not a strategy I'd recommend. I wonder what you think.

What should the Dow Jones be worth?

The Dow closed yesterday at 13,358.31; ten years before, it stood at 8,254.89. That's a compound annual growth rate of 4.93% (less, when you adjust for inflation).

Or if you take it from the big, big scare of Monday 19 October 1987 (close: 1,738.74, down 508 points from the previous Friday!), it's an average 10.88% compound per year. Does that seem too hot a pace? Unsustainable? But remember that we're starting that run from a real panic. If we took it from the happy close of the Friday before, the average becomes 9.53%.

Still too hot? If nearly 20 years isn't enough to establish a sensible long-term trend, let's look at an even longer period: 30 years from 30 July 1977. Then till now, the Dow's capital growth averages out at 9.45% compound per year. The market's folly can outlast your wisdom.

"Two views make a market", and that's it. Mr Market is making his wares available to you - will you buy at today's prices? (I wouldn't - but obviously others will, or the market would be lower.)

You can play with the figures yourself, on this fine page from Yahoo! Finance.

And please click on the poll opposite, to give your prediction for the year's end.

Have I got my sums wrong - or right?

Bill Bonner, in The Daily Reckoning Australia yesterday, quotes Paul van Eeden as saying that gold has kept pace almost perfectly with inflation since the 1920s.

My post of 29 July did some figures with US gold stocks, the price of gold and the money supply, and came to an arresting conclusion. A kilo of gold costs x dollars, yet at that price, all US gold could be bought for 1/66th of all US dollars. There'd be a huge pile of spare paper money left over, completely unrelated to gold.

From one point of view, the current gold price is not surprising, if gold is merely one tiny part of the overall economy governed by the dollar system. Yet the ratio in the previous paragraph - 1:66, which is the same as 1.5 cents to 1 dollar - is almost exactly what The Mogambo Guru (Richard Daughty) said is the difference in purchasing power between one modern dollar and one 1913 dollar. According to him, the modern dollar is worth two 1913 cents.

Perhaps Doug Casey is right: if trust in the dollar collapses, gold could be "going to the moon".

We need bad times

iTulip has just issued its latest email newsletter - I do suggest you subscribe, especially since it's free.

Their thesis this time is that the Dow will NOT continue to rise much, because the private investor isn't going to come in and be fleeced again. It's not just "once bitten, twice shy" but the fact that money's getting tighter (energy and food costs rising, etc) and the value of assets (especially houses) is in question. On the other hand, iTulip are not doomsters, either.

My view, for what it's worth, is that we have to wait for something unexpected to trigger a real correction, but the sooner it comes, the better. While our governments put off the evil day with borrowing and monetary inflation, our productive capacity is being exported. One firm I know is having an (atypical for here) bumper year; but whereas once their business used to be moving other people's machinery from one site to another, now they're shipping it abroad. How do you make a living if you sell your tools? Even administrators in bankruptcy can't force you to do that. But the economic folly of our rulers can.

In the British Midlands where I live, I've heard engineers complain (like Lewis Carroll's Oysters) about industrial decline ever since I attended a British Association for the Advancement of Science conference in 1977, but our leaders have plodded on, chatting comfortably to each other like the Walrus and the Carpenter, while the Oysters' numbers dwindled. I drive past new man-about-town city centre flats where only 17 years ago I was talking to a self-employed woman turning metal parts. The mighty Longbridge car plant is a broken shell, and the surrounding area is turning over to drugs, alcohol, crime, teenage gangs, domestic abuse and all the rest.

The system continues apparently unaffected, but I think it's a fool's paradise. Only last night, I watched a TV programme about India. The city of Bangalore (home to tech giant Infosys) is modernising and booming; its university aims to attract the world's best. When industry and learning have gone East, what exactly will the West have that anyone could want? We'd better start making it again now, and at a price that our trading partners are willing to pay. Or at least, make sure we have what we need to produce what we consume, as locally as possible.

Yes, currency devaluation means inflation and recession, but better that than a full-on, generation-long depression. We've got to take the nasty-tasting medicine while it can still make a difference. But who will force us to do it?

The US Presidential elections are still a year away, and the new President won't take over until January 2009. In the UK, we have a Prime Minister we didn't elect, who could choose to defer the next General Election right up to 2010. If we're going to get the right people to deal with the heavily-disguised crisis we're in today, the economic issues will have to break out into the open within the next 12 months.

In the meantime, investors must prepare for turbulence.

Gold and M3 (US)

According to GoldPrice, gold today is going for $21,242.64 per kilo. The World Gold Council says that as of June 2007, the USA holds 8,133.5 tonnes of gold. So that means America's gold stock should be worth $172.777 billion.

This site says "as of early 2007, M3 is about $11.5 trillion", which is 66.56 times the value of US gold reserves. So if everybody insisted on having their money out in gold, which they can't do any more, they'd get about 1.5 cents-worth back for every dollar they were owed.

I suppose that's what inflation means.

UPDATE

Wikipedia says, "As of 2006 the required reserve ratio in the United States was 10% on transaction deposits (component of money supply "M1"), and zero on time deposits and all other deposits."

If reserves and loans were all the money we had, then using a ratio of 1:10 for all of it (and it's worse than that!), the nominal value of bank reserves would be something like 6-7 times what they could buy in gold at current rates. Surely I've got this wrong?

Bargain hunting

I've been looking for something to illustrate how you can take advantage of pessimism.

Here is a blog about Consett, a small town in the North of England that was shattered by the closure of its main employer, a steelworks. The writer says (28 Dec 2006 entry), "I came across a copy of the Consett Guardian from 1983 - the year when you could buy a house for just £10,000..."

I looked on NetHousePrices for houses sold during 2006, to get an idea of the cheapest in a whole 12-month period. A terraced house is one joined to other houses left and right: the lowest individual sale price I could find for last year was £42,000. Yes, it's much lower than the national average for such properties (£186,316 according to the 9 March 2007 article on this site), but had this house in Consett sold for that £10,000 in 1993, the new owner would still be looking at a capital gain of 6% compound per annum. The article just mentioned gives an average Northern terraced property price as £125,058, and the Consett street that had most (27) sales of such properties last year showed an average price of £127,733.

So what happened to Consett? Their MP Hilary Armstrong explains:

...contrary to predictions the people of the district did not let the town die. After the closure, Project Genesis was launched to revive the local economy and regenerate the town. New industries have arrived, such as Derwent Valley Foods and aerospace company AS&T and unemployment is now down to the national average level. The site of the Steel Works has been reclaimed with new housing, a retail park and environmental landscaping. There is still a long way to go but Consett is still very much alive and is now seen as a successful case study in regeneration.

Financial experts like Bill Bonner and Marc Faber have revealed their purchases of cheap agricultural property in selected areas around the world; and sure enough, there's people out there now in the US who have spotted the opportunity in depressed housing areas like Detroit.

The worst hasn't happened yet, in any case - but think of bargains, when others can only see ultimate defeat. Remember Sir John Templeton.

And another thing...

Surely, people who can't afford their mortgages don't have big investments. So aside from default losses impacting on portfolios, I don't see a great need to sell one's holdings (or a wonderful opportunity to buy).

But when the market is worried, private investors tend to get rid of their stocks, which as they drop in price are snapped up by the patient, crocodile professionals. Watch for data on the changing proportion between private and institutional holdings - please let me know when you spot it.

Pessimism overstated?

Seeking Alpha has a useful round-up of stats and news items on the US housing debacle.

I shall try out a contra-contrarian position here.

It's obvious that adjustable-rate mortgages (ARMs) will pose a problem for American borrowers as they emerge into a variable and now-higher interest rate environment. We are approaching a peak in this process around October/November and again, that's known about, so with all the belated hoo-ha in the media now it should be factored-in to the market.

The packaging of mortgages into collateralized debt obligations (CDOs) and their sale to perhaps naive institutional investors, is now better understood and has started a bout of worry that has spread to prime lending, too. So we have a reasonable dose of pessimism in the mixture, with Michael Panzner and Peter Schiff ensuring we're taking the medicine regularly.

One of Michael's posts last week included a detail of a "charming colonial" house in Detroit going for $7,000. Over here in the UK, somebody screwed a 0 to the side of our house prices over recent years, and if I was shown a residential property fund that would snap up streetsful of properties like the one in Detroit and wait for the turnaround, I'd be tempted.

When recession hit the UK in the early 80s, house prices plummeted in Consett, a Northern steelworking town where the local works - the main employer - closed and unemployment rose to 36%. Now the median price is £152,000. This was a working-class town, not a fashionable area, and at that time (1981) the national average house price was £24,188. So even if you'd bought a house in Consett at that price (and because of unemployment and deep pessimism, it would have been far less), you'd have made a 7.3% compound pa capital gain in the 26 years since - plus income from rent, less expenses.

I don't think the housing market runs the economy, it's the other way round. When we have a real economy, our wealth will be more secure. Perhaps the USA needs to wait for a fresh President who can take tough decisions early, in time for the fruits of his/her labours to show and be rewarded with a second term.

It's early days, but the pessimists in my Dow poll (see sidebar) have the upper hand. I still think there may be a small bounce by the end of the year, when we've digested all the bad news and are ready for a sweet. Please cast your vote!

Who's got the gold?

According to latest World Gold Council figures (June), these are the biggest gold hoards held by individual nations and organisations, in descending order (countries not listed have less than 1% each):

United States, Germany, IMF, France, Italy, Switzerland, Japan, ECB, Netherlands, China, Taiwan, Russia, Portugal, India, Venezuela, Spain, United Kingdom, Austria, Lebanon.

The first 3 above account for nearly 49% of the world's stock, with the USA alone (since the dollar is the world's reserve currency) owning 26.77%.

The Central Bank Gold Agreement organises the buying and selling of gold by its member countries, to provide some price stability. Since the start of this year, the main change has been Spain's sale of 19.11% of its stock.

Figures are available from Q1 of 2000 onward. From then until now, here are the significant moves:

SALES (expressed as a percentage of each country's stock held as at Q1 2000):

Switzerland 50.19%
UK 47.25%
Portugal 36.94%
Spain 35.60%
Netherlands 29.71%
Austria 29.14%
ECB 14.14%
France 11.37%
Russia 4.95%
Germany 1.33%

On average, all gold-holding countries reduced their stock by an average of 9.89% over these 90 months; signatories to the Central Bank Gold Agreement reduced theirs by around 16 to 17%.

ACQUISITIONS (expressed as a percentage of each country's stock held as at Q1 2000)

China 51.89%
Venezuela 14.71%
Japan 1.55%

Venezuela has less than 360 tonnes; Japan hasn't added much percentage-wise. So the odd man out is China. China now has 600 tonnes and is in 10th place, rising from 395 tonnes (16th place) in 2000. It made major purchases of about 100 tonnes each at the end of 2001 and 2002.

Peter Schiff: US Treasury less creditworthy

Peter Schiff in FXStreet today mounts a vigorous defence of his record of warning us that subprime problems would spill over into other credit areas. The market appears to be waking up to this, but he says there's worse to come:

A much larger disaster looms for holders of U.S. dollar denominated assets in general. It will not be long before our foreign creditors realize that Uncle Sam is the biggest subprime borrower of them all and will similarly mark down the value of its debts as well.

Once again, why has Britain recently become the third-largest holder of American debt? Our exposure is now 3 times higher than about a year ago.

New Growth Theory and Friedman's "Flat Earth"

Here's an interview with Thomas Friedman in Yale Global Online (18 April 2005). Some quotes, with the issues I see in them italicised:

Lean thinking:

Wal-Mart doesn't make anything. But what they do is draw products from all over the world and get them into stores at incredibly low prices. How do they do that? Through a global supply chain that has been designed down to the last atom of efficiency. So as you take an item off the shelf in New Haven, Connecticut, another of that item will immediately be made of that item in Xianjin, China. So there's perfect knowledge and transparency throughout that supply chain.

International trade vs local social costs:

The consumer in me loves Wal-Mart... And not just me... Some lower-income people are stretching their dollars further because of Wal-Mart...The shareholder in me... loves Wal-Mart... The citizen in me... hates Wal-Mart, because they only cover some 40 percent of their employees with health care... [For the rest,] we tax-payers pay their health care. And the neighbor in me... is very disturbed about Wal-Mart. Disturbed about stories about how they've discriminated against women, disturbed about stories that they've locked employees into their stores overnight, disturbed about how they pay some of their employees. So... I've got multiple identity disorder, because the shareholder and the consumer in me feels one thing, and the citizen and the neighbor in me feel something quite different.

New Growth Theory issues:

What is the mix of assets you need to thrive in a flat world? Money, jobs, and opportunity in the flat world will go to the countries with the best infrastructure, the best education system that produces the most educated work force, the most investor-friendly laws, and the best environment. You put those four things together: quality of environment that attracts knowledgeable people, investment laws that encourage entrepreneurship, education, and infrastructure. So that's really where, in a flat world, the money is going to go.

And I don't really believe much in foreign aid because I think, at the end of the day, that's not how countries grow and get rich. But to the extent that you are going to give foreign aid, it should be to inspire, encourage, and help develop one of those four pillars for whatever developing country you're dealing with. But I do believe in trade, not aid. I think that axiom still applies, even more so in a flat world.

Security:

The flat world is a friend of Infosys and of Al-Qaeda. It's a friend of IBM and of Islamic jihad. Because these networks go both ways. And one thing we know about the bad guys: They're early adopters...

Trade, nationalism and peace:

...what I call the "Dell Theory" – you know, Dell Computers. The Dell Theory says that no two countries that are part of the same global supply chain will ever fight a war as long as they're each still part of that supply chain... here's what I predict: If you do go to war and you're part of one these supply-chains, whatever price you think you're going to pay, you're going to pay ten times more. Once you lose your spot in the supply chain because you've gone to war, the supply chain doesn't come back real soon. They're not going to. Fool me once, shame on you; fool me twice, shame on me. That's why you really risk a lot. And that's why these supply chains now really mean a lot. They're the new restraints.

Anti-globalization:

The anti-globalization movement ... is basically dead today – because China and India have embraced this process and this project... The anti-globalization movement... [are] all still talking about the IMF and the World Bank and conditionality – as if globalization is all about what the IMF and World Bank impose and force on the developing world. Well when the world is flat, there's a lot more globalization that's about pull. This is people in the developing world – in China, Russia, India, Brazil – wanting to pull down these opportunities.

Intellectual property rights:

Look at what happened in [India] with intellectual property law... there's no question that we did want India to have intellectual property protection to protect our products... But what it turned out was that a lot of Indians wanted it as well because they become innovators themselves. They are now plug-and-playing in this world and they want the intellectual property protections for their innovations.

Failure of Western technical education:

There is a crisis. We're not producing in this country, in America, enough young people going into science and technology and engineering – the fields that are going to be essential for entrepreneurship and innovation in the 21st Century. So we're at a crisis – it's a quiet crisis, as Shirley Ann Jackson from the Rensselaer Polytechnical Institute says. If we don't do something about it, then in 10 to 15 years from now this quiet crisis will be a very big crisis. And that's why my friend Paul Romer at Stanford says – and I totally agree with him – is a crisis is a terrible thing to waste. And right now we're wasting this crisis.

New Growth Theory: should we pay handsomely to make ideas free?

When Tony Blair became Prime Minister, his slogan was "education, education, education". We thought he was merely reflecting our discontent with schools, but now I'm not so sure.

In 1994, Gordon Brown was quoting a new economic theory by - google him up - PAUL ROMER. Here is a 2001 interview in Reason Online with Romer. It turns out this may be to New Labour what Sir Keith Joseph’s espousal of monetarism was to Margaret Thatcher’s premiership. “New growth theory” is by Paul Romer, and bears on:

• education (a key slogan in Tony Blair's election campaign)
• skills training for workforces (a UK government initiative currently advertised on TV)
• intellectual property rights (relevant to design and patent theft by foreign manufacturers)
• free trade/globalisation

It has some intriguing aspects, but could also be a gift to the anti-big-business Left.

A core debate in this theory is the ownership of knowledge. Romer says that price is both an incentive to the producer, and a means of deciding who gets the product (or what product they choose). An example he gives in his interview is the life-saving treatment for children with diarrhea in poor countries:

...the efficient thing for society is to offer really big rewards for some scientist who discovers an oral rehydration therapy. But then as soon as we discover it, we give the idea away for free to everybody throughout the world and explain "Just use this little mixture of basically sugar and salt, put it in water, and feed that to a kid who's got diarrhea because if you give them pure water you'll kill them."

So with ideas, you have this tension: You want high prices to motivate discovery, but you want low prices to achieve efficient widespread use. You can't with a single price achieve both, so if you push things into the market, you try to compromise between those two, and it's often an unhappy compromise.

Ideas can be duplicated easily and cheaply, but they often cost a lot of money to come up with. For example, pharmaceutical firms do hugely expensive R&D - could they recoup the cost of successful solutions, and all the unsuccessful ones, via a prize competition? What happens if they go bust a yard before the finishing line?

What about areas where the humanitarian argument may be weaker? What if some Far Eastern car factory comes up with a tweak on, say, the Wankel engine design and goes into very successful (and low-labour-cost) production, paying nothing to the people who came up with 99% of the ideas? Sir Tim Berners-Lee (may we never forget his name) gave away the Internet, but should all hard-won knowledge be free?

And what exactly are the implications of a "knowledge economy"? Does State-organised education, with its top-down management, encourage the development of the creativity we need? Do we need 50% of our young people to go to college? Should they choose their subjects, or be told what to learn? Should they be given incentives to study in areas that are thought to be important? How far should we be prepared to fund research that has no immediately foreseeable practical application?

Romer is certainly right in saying that a smart workforce is an asset (and a smart management - we could do with some de-Dilbertising), and that there's lots of potential in continuous, incremental improvement. "Lean thinking" may buy us time in the destabilizing conditions of a globalized market - if we use our brains to improve what's in front of us at work every day, we may not go bust quite as fast as the doomsters fear.

But as the economist himself admits, it's a can of worms.

A Bluffer's Guide, Part Zero

The new British Prime Minister, Gordon Brown, has a reputation for being fearsomely intellectual. In a speech back in 1994 he referred to "post neo-classical endogenous growth theory", a shut-'em-up phrase if ever there was one.

Except with Members of Parliament, who are no strangers to bull, many of them having buffed up their chatter muscles at Oxford and Cambridge. Michael Heseltine (Pembroke College, Oxford), then President of the Board of Trade for the Conservative government, suspected Brown (Edinburgh) had gotten this showy material from his economic adviser, Ed Balls, and drawled, "It's not Brown, it's balls."

For in most cases, you can say it more simply. Or if you prefer, you can go ahead and hit people over the head with it, but be prepared to clarify if challenged.

So I've looked for relatively simple explanations of EGT (shall we who are now in the know agree to use this outsider-excluding acronym?). Here's what I've got so far:

Endogenous growth theory - from Investopedia

And here's something else worth reading, by Gladys We. It is a few pages long, but it explains it well enough so I can understand it - I think.

Politically, it seems EGT can be used as an argument against free trade and intellectual property rights. For the latter, see page 5, point 5; okay to steal someone's ideas, refine them and then copyright them. I'm sure there's Far Eastern firms that'd be fans of this policy; something to advocate amiably over the pre-prandial sherry in the Senior Common Room - until you put it into practice by plagiarizing the Master's work.

UPDATE (Saturday morning):

It's now called "new growth theory". EGT is so last evening.

October 1987 revisited

I'm trying to work out whether making an historical analogy with 20 years ago is valid.

Let's have a look at what has happened to prices. Cliff D'Arcy in The Motley Fool (22 May 2007) does a very informative comparison between houses and the FTSE 100. He reminds us that although the FTSE-100 dropped dramatically on "Black Monday" (19 October 1987), it ended about 2% higher over the year as a whole. If we take his figures for 1987 to 2006, house prices increased 287%, and the FTSE 263%. This would suggest that house prices and stock prices have increased about equally (though houses cost money to run, whereas shares pay dividends).

Are British people over-borrowed? This Bank of England research document from September 2004 says not, in relation to house prices. Yes, debt-to-income has gone up, but interest rates are now low. And despite its name, the latest survey from UK site HousePriceCrash indicates a general belief that house prices will continue to rise in the months ahead. (But recent first-time buyers will be more vulnerable, having little equity and probably a high income multiple for their loan.)

I find the monetarist arguments intuitively persuasive, but I'm puzzled by the disparity between prices and monetary inflation. Using the UK's M4 stats, over the 78 quarters from Dec 1987 to March 2007, the average annualized increase in the money supply is about 10.48%. Compounding that figure, we get about 7 times more borrowed money in the system today than in 1987. Yet houses and shares are only 3-4 times higher.

What does seem clear is that we have borrowed more in relation to income, and this makes it even more important not to lose your job, or be hit by high interest rates. It's worrying when you have to depend on things carrying on as they are, indefinitely.

2007 = 1987?

Greg Silberman in Safe Haven yesterday uses the chartist approach to suggest an analogy with the lead-up to the 1987 crash.

I don't know. Over the late '86/early '87 period I watched my little investment soar and began to wonder how everybody could get rich at the same time. I heard reports that people were borrowing against their houses to trade, and schoolboys were making money on the market. I don't read quite that degree of crazy optimism and greed today.

Maybe the difference is reflected in the degree of monetary inflation. In the UK, the 3 years leading up to October 1987 showed an average annualized increase in M4 of 18.59%, compared with an average 12.07% annualized over the 12 quarters to March 2007. And over here at least, people are much more leery of investments and pensions than they were then.

But there's loads more debt now. It could be that a drop happens, not because of a change in investor confidence, but on account of running short of spending cash.

Cycles and charts

For the analytical, here's an essay on Kress Cycles in Safe Haven.

This, together with Kondratieff cycles and other patterns used by market chart-interpreters, has one flaw to my not-quite-so-mathematical mind: predicting human behaviour involves feedback loops. If I secretly write down what I think you're going to do tomorrow, I could be right every time; but if I reveal my thoughts to you, that changes the situation. It's a sort of Heisenberg uncertainty principle: to observe is to be involved, and therefore part of the nexus of causes.

Having said that, human behaviour does have patterns, and I believe some have theorised that the growth of our brains is in response to the competition to predict the other person's behaviour better than he can predict yours.

Gold - or cash?

Brady Willett in Safe Haven (yesterday) warns us off some "bright ideas" for preserving wealth in a market drop. He notes that gold is a hedge when everyone wants out of cash, and that's been quite some time.

I guess his position is close to that of Marc Faber, who said recently that all asset classes are inflated and on the whole, he'd prefer to stand on the platform rather than get on any of the waiting trains.

Is the credit system cracking up?

Bob Hoye, in Prudent Bear (yesterday), discusses "the Unholy Trinity of central banking, derivatives and artificial rating of credit". He sees these as systemic risks - I'll say more about that when I come to Richard Bookstaber's interview on Financial Sense last Saturday.

Should US Treasury bonds be downgraded?

iTulip's President, Eric Janszen (Wednesday) goes over the now-familiar arguments for a coming period of US recession/inflation, caused by the trade, budget and fiscal deficits.

He also links to Paul Farrell's article in Marketwatch (Monday), which questions America's creditworthiness as a result of having to finance the war in Iraq. Maybe we're going around the same track as with Vietnam, which burned up money (I remember a contemporary American cartoon of a steam engine with dollars being shovelled into the firebox).

Has the UK tied one of its little boats to the anchor chain of the Titanic? I calculate its loan to Uncle Sam's Treasury to be worth $2,757.65 per capita (British heads), or £1,345.99.

My wife and I could have a nice little holiday on that, which would be more fun, or a day at the races, which might get us a better return.

Desperately holding down gold

Jim Willie of the Hat Trick Letter thinks that bank selloffs of gold are to make dodgy bonds look better than they are. If the mortgage bonds unravel, there's a lot of fast talking to be done by banks and brokers.

More on US housing woes

An informative piece in Dr Housing Bubble on the various factors that are turning the housing market upside down.

If I read the first graph rightly, there's a peak in the numbers of temporarily-fixed US mortgages that are due to come back onto the current variable rate in November this year, which suggests we may have a difficult autumn ahead. Further cutbacks in discretionary spending, presumably.

Bank of England investment in US Treasuries; gold

Let's combine the recent mystery about Britain's massive investment in US Treasury securities, with the worldwide asset bubble.

This is Doug Casey speaking to the Agora Financial "Rim of Fire" conference in Vancouver this week, on YouTube (thanks to "Daniel" for alerting me to it).

His view on American bonds? "A triple threat". Why?: (1) interest rates are very low and are going to become very high; (2) credit risk: he says he would not wish to be a lender now, with so much debt everywhere -he refers to a possible "financial credit collapse"; (3) currency risk - he says dollars say "IOU nothing", and compares them to the Argentinian peso 10 years ago.

So, why has the UK invested an extra $112 billion in US-dollar-denominated Treasury bonds, between June '06 and May '07? To dramatise this figure somewhat, let's look at the Forbes list of the richest people in America (Sep 2006): the top 5 billionaires are worth $155 bn between them. Britain is now into America for $167.6 bn. The increase in the last year alone is more than the net worth of Bill Gates and Warren Buffett combined. I wonder (rhetorically) whether they would bet their entire fortunes on US Treasuries?

We already know what Casey thinks about cash held in dollars, and he regards stocks and property as overvalued, too.

So what does he favour? Gold. "It's not just going through the roof, it's going to the moon". He's been a gold bull for the last 7 years. He picks mining stocks, but warns that they are very volatile, even more than Internet stocks. But there are other ways to own gold.

Meanwhile, is there anyone here in the UK who is willing to grill the supposedly independent Bank of England (it wasn't the British Treasury, after all, it seems) about the rationale for its vast punt on "triple risk" US bonds?

Let's finish with Bill Bonner's keynote speech at the same conference, on the difference between the real boom of the Far East and the Ludwig von Mises "crack-up boom" of our inflationary economies:

Futurology

Continuing the argument about sovereign wealth funds, what might this portend for US Treasury securities?

If foreign governments pull the rug out, there could be a run on the dollar on a scale that the US government wouldn't dare correct with proportionately high interest rates, seeing how indebted everyone is. The doomsters are probably right that it could happen, which is why everybody will make sure it doesn't.

And such a fall wouldn't be in the interest of creditor nations who still value the trade surpluses they enjoy with Uncle Sam. Many Chinese light manufacturing industries are working on narrow margins and don't want to see their profits disappear through foreign exchange movements (though their State is sufficiently powerful and ruthless to go that way if it wants to). I suspect that China will continue to develop towards heavier industries and gradually allow the trainer-stitching work to go to even poorer countries like Vietnam. Meanwhile, it's in no hurry to kill the US cow while she's still giving milk.

So here's my bet:

1. For domestic political reasons, the US will not do what is needed to get the economy back on the level. It will continue to borrow but, fearful of its vulnerability to potentially unfriendly foreigners, lean on its friends for more finance.
2. The US Treasury securities held by China will remain much the same, or even gradually increase in dollar terms, but "ally nations" will increase their holdings proportionately faster. There's not much an emotionally or politically vulnerable British PM won't do for a pat on the back at G8 summits, Bilderberg tie-looseners etc. Goodness knows how much of our future has been sacrificed to the last one's ego.
3. Creditor nations will increase their sovereign wealth funds, favouring investments that are involved in the supply lines from their manufacturing concerns to our end purchasers. Marxism has moved on: you have to have control of the means of production, but even more so of the means of distribution.
4. They will also invest in the lines leading towards their industries: energy, industrial metals and infrastructure. I also guess China will explore healthcare, energy-efficiency, food-oriented genetic research and environmental protection. And water. And foreign farmland (Bill Bonner and Marc Faber are really smart). City planning in all its aspects could become really important.
5. If these countries were private investors, we'd be seeing their portfolios alter their balance between bonds and equities, in the direction of higher risk, higher returns. And like good long-term investors, they will get richer. Maybe eventually, as James Kynge says, demographics and healthcare will eat into this wealth, but it's not going to benefit the West much either way.
6. In the US and the UK, our collective concern will be how to handle the social disruption in our own societies; our concern as individuals will be how to save and invest while we still can, and how to set up our own children in relative security.

Place your bets

The Dow Jones Industrial Average closed yesterday at 13,785.07. Where will it go? Please see the survey on the right.

Here's an idea: the doomsters may be correct in their analysis, but wrong in their prognosis. If sovereign wealth funds continue to grow, we may see a new type of massive institutional investor, one that has no plans to retire or die. So ownership of American, British and other Western countries' businesses will shift to the East.

Initially, this will seem to make little difference, except that the markets may become better-supported against falls and may trend upwards, long-term (in currency terms; I'm not so sure about inflation-adjusted terms). But the dividends on foreign-owned shares will not accrue to the host countries, and so the US and UK will bleed from two wounds: trade deficits and accelerating loss of investment income.

If small businesses are eaten by big businesses, and big businesses have been taken over by sovereign wealth funds of other nations, the result for us may be not only economic impoverishment, but a form of slavery, since we will have lost control of our means of production. All we will have left is our labour, and in world terms, you and I are grossly overpaid. There is an developing Eastern middle class that can and will do everything better, faster, harder and cheaper than you. Many of them speak better English than the English.

Look at the businesses these sovereign wealth funds are going for. China: $3 bn for a 9.9% stake in giant US hedge fund Blackstone in May this year, and now (with Singapore) 10% of Barclays Bank (UK); Qatar: Sainsbury's (UK supermarket chain). These investments involve commercial property, finance and retail distribution. I've recently relayed James Kynge's statement that Chinese manufacturing only gets them 15% of the end price; now they're after the other 85%. I shouldn't be surprised if we start to see acquisitions in marketing and advertising firms, too.

What to do? I think:

• Work hard and earn as much as you can, while you can.
• Look after your health. Better not to get sick in the first place, than hope for "healthcare" to put Humpty Dumpty back together.
• Live simply and well within your means. Do you need a car? One that size?
• Pay off debts as fast as possible.
• Save and invest.

And if you have time and don't mind potential official surveillance and bullying, give your politicans earache about their incompetence, which is on a scale that to some might seem almost treacherous.

They are the masters now - or will be soon

The BBC Ten o' Clock News last night featured an article about China's purchase of a share in Barclays Bank. I have posted a video of part of Chris Mayer's speech at Vancouver (see below), where he discusses "sovereign wealth funds".

China, India and Japan have enormous surpluses of money from their trade. They have bought US Treasury securities (bonds, i.e. loans to the US), but this is a thing governments do to park money that they might need back in year or two, when the trading balance has altered. Since the US/UK (etc) trade deficits are long-running, these eastern countries can now start thinking like young private investors, in which case equities become attractive - offering income from dividends AND the potential for capital growth.

These countries are turning our debt into their ownership, like an old Punch cartoon where a plumber took his customer's house in payment for his work.

This issue is big.

Prohibition: Uncle Sam beat Eliot Ness

Don Boudreaux, of Cafe Hayek fame (see blogroll), writes that Prohibition ended, not because of popular demand, but because the US government was running short of tax money in the Depression.

It's an interesting theory. I have long thought that the UK government is more hooked on cigarettes than the smokers. If they really wanted to ban smoking, they'd start by cutting the tax, so as to wean themselves off financial dependence. But how would they replace the lost revenue?

Familar themes, and a sales pitch (not mine!)

This is NOT a recommendation, but you may be interested in the general trend of thinking it reveals: The Daily Reckoning features a sales spiel for a newsletter from Tim Price, which passes on pessimistic comment on the near future of the markets, and indicates four areas for investment:

"Portfolio insurance"
Infrastructure (e.g. roads, railways)
Gold
Oil

We are seeing these themes crop up again and again among the contrarians. Though I'm not quite sure what is meant by the first - unless it's futures and options, which make me nervous.

Chris Mayer at Vancouver, on China

"Daniel" has responded to an earlier post re rail revival, to say that Chris Mayer's speech at the Agora Financial symposium in Vancouver has now been put on YouTube. Here it is, with my thanks to Daniel: