My grandfather gave me $10,000 in 1991. My grandfather gave me $10,000 in 1991. As soon as I held the check in my hand, I only had one thought: gold! That was a long time ago, and that investment paid off big-time. But my motivation for investing in a gold mutual fund in 1991 is even stronger today. Let’s take a look at the global macro situation and see how likely gold will increase in value in the near future.
The U.S. is the largest global economy and is in a mess that is only getting worse. Starting in 1972, the U.S. stopped generating enough wealth to increase real wages for the middle class. Subsequently, the real-wage for the middle class peaked in 1972. By the end of the 1970s, we were faced with what was called economic malaise, another term of the time was stagflation. I remember buying my first car in 1980 and paying a 20% interest rate.
Reagan was elected in 1980 and our national debt was less than $1 trillion. What did he do? He asked his economic advisors what would get the economy going. They gave him Keynesian economics. Subsequently he stimulated the economy with huge budget deficits, and guess what? It worked! By the time he left office in 1988, the economy was roaring. However, to get this growth, the deficit had nearly tripled in size to $3 trillion. And because it worked, every president that followed him used the same playbook. Today we have a deficit of $17 trillion, and if interest rates rise a mere 2%, the U.S. is bankrupt, unable to pay its debt obligations.
Keynesian economics was also called voodoo economics back in the Reagan era. And rightfully so, because you can’t print your way to prosperity. But the Fed, Congress, and the President do not know of an alternative. And it isn’t just the U.S. that is using this dangerous game of utilizing debt to stimulate growth. Both Japan and Europe are also caught up in the debt fiasco.
What you need to understand is that the U.S. has no right to be living high on the hog with perhaps the highest standard of living in the world. We have not earned that right since 1972. We should have seen our standard of living drop in 1980s. But Reagan chose the devil’s alternative – debt - and soon we are going to pay the piper. The U.S. has been avoiding the inevitable for over 30 years and the clock is ticking. Our standard of living is going to drop, and when it does the dollar will no longer be the global reserve currency. This will lead to a devaluation of the dollar and all kinds of fallout.
Another key thing to understand is that the financial system is a house of cards held together with over $500 trillion in interest sensitive derivatives. The derivative nightmare was the outcome of the Keynesian economic policies of the last 30 years where debt created abnormally high risk. A derivative is supposed to be insurance to protect you. However, your insurer has to be solvent. This is called third-party or counter-party risk. If these derivatives start to melt down, no one is getting paid. It’s very similar to FDIC insurance. The insurance fund is only big enough for small to medium size banks. Anyone who has money in a large bank is deluding themselves if they think their money is insured. Likewise, a derivative is only good if it is used during a period solvency.
The financial system is highly integrated. It is a global system. It works fine if you have wealth generation and low debt. However, both of these have been eroding, and at a faster and faster rate. With $100 oil, generating wealth has become more difficult. And with low GDP rates, debt has been growing at nearly exponential rates.
Have you seen a U.S. debt chart since 1980? Here, check this one out:
By the end of 2014, the U.S. will have $18 trillion in debt. That is a huge number, but since we only know Keynesian economics, the number just keeps growing. At some point, either the Chinese or the Japanese, who both own more that $1 trillion of our debt, will realize they are not going to be paid back. At that time, they will begin a game of chicken – who will sell first. I find it interesting that they don’t like each other. Do you really think that one of them will sit back and let the other sell half of their bonds? Not a chance. Once one of them begins to sell, it will be game on, and a race for the exists.
Currently, the U.S. can only generate about $2.7 trillion in annual income. However, we are currently spending about $3.5 trillion. And if interest rates rise by 2%, we will need about $1 trillion just for interest payments. That’s called bankruptcy. The Fed cannot come to the rescue and print money to pay the interest. If they try, at some point you get hyperinflation.
When Lehman Brothers declared bankruptcy, I was pretty sure that was it for the U.S. At the time, I didn’t realize the Fed could get away with printing money to keep the economy from imploding. But this game of trying to print your way to prosperity has its limits, which we are approaching. You are already seeing the Chinese steadily move away from the dollar in their international transactions. And you are seeing the Chinese buy gold in large quantities knowing the U.S. economy is playing a dangerous game. They smell blood in the water.
Abenomics in Japan is another dangerous game. This is not normal behavior for a very large economy. They have devalued their currency by 30% in less than a year against the U.S. dollar (80 yen to 105 yen). That is a sign of desperation. They also have 200% debt to GDP, and they have the Fukishima disaster which seems to be getting worse.
Europe is on life support. The economy is not improving and the debt situation has not gone away. It seems like their only policy is sell all of their gold to China. I think Europe is in a holding pattern and will continue to bailout any crisis that erupts. They seem to be waiting for a miracle, and will do whatever they can until it arrives. However, once either the U.S. or Japan begins to falter, Europe will go down hard with them.
For those of you who think the global economy can come back to life, consider that shale oil requires at least $80 oil. And without shale oil, you have an oil shortage and $150 oil prices. Thus, the floor for oil is about $80. In other words, we will not see cheap energy in the near future. And without cheap oil, it is going to be nearly impossible to get a global growth rate above 3%. What is more likely to happen is a stagnant global economy until the debt situation unravels. As I like to say, we are in a countdown. And the outcome will be much more like a bomb than a new year’s eve party. Scary? Yes, but that is the reality of what we are facing. Unless, of course we get that miracle that Europe seems to be waiting for.
Okay, you have read my analysis. If I am right (and I think the facts are on my side), then gold is the one asset that will benefit. It has to. I knew this in 1991, and I am more sure today. Even if you dismiss the huge increase in the global money supply since 1980, when gold reached $850, the number of wealthy people who can afford gold is probably 10 fold what is was in 1980. If there is even a minor trend of people converting their assets into gold, the ramifications for the gold price could be staggering. I don’t know if we will see $10,000 gold, but $5,000 will not surprise me.
I do want to add one caveat. While I am confident a bottom in gold will get set, and then we will see much higher gold prices, the actual bottom and the timing of the bottom are unknowns. Many people are predicting $1,000 gold and Harry Dent is predicting $700 gold. The bottom might be much lower than I am anticipating. If we do get $700 or even $1,000 gold, you can expect mining shares to fall hard. So, substantial risk still exists. On a positive note, if that happens, the average mining stock will be a 10 bagger, and I will finally get to buy Endeavour Silver at $2.50 a share.
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