John Williams Eyes Gold as Insurance Against Armageddon
Interview

The Gold Report: In our last two interviews, you noted that based on the contraction in the M3 in 2009, you anticipated a resulting contraction in the general economy six to nine months later. Are you seeing that impact yet?

John Williams: Just to be clear on what's involved. . .I continue to track M3, the Fed's broadest measure of the money supply until it ceased publication in March of 2006.Generally, the broader the measure of systemic liquidity, the better it serves as a predictor. In terms of giving a signal for the economy, you have to adjust the growth for inflation. What's happened historically is that every time the year-to-year change in the inflation-adjusted M3 has turned negative, the economy has followed in a recession or if already in a recession, the downturn has intensified.

Those signals don't come very frequently; but when they do, they are extremely reliable. There have been cases where a recession was not preceded by a contraction in the money supply, but whenever you contract liquidity, you can contract the economy. (Check out more of John's insights about this phenomenon in his Gold Report interview published on August 6, 2010—Editor.)

We had a signal in December of 2009 that indicated an intensification of an already extraordinary downturn six to nine months down the road. I think we started to see this in the economy last September. Payrolls peaked and started to turn down again in that timeframe. That's adjusting for the massive benchmark revision that will be published in February. Although industrial production had been rising, it looks as if it also peaked and started to turn down again in September/October. I'll contend that consumer confidence is more a coincident indicator than a leading indicator, but it peaked in the July/August timeframe.

The way I describe the economy is that it started turning down in 2007, plunged throughout 2008 into 2009. Basically, it has been bottom bouncing ever since. I'd caution anyone that we're seeing extraordinary distortions in economic reporting, due primarily to the system never having been designed to handle a downturn of this severity. Post-WWII economic reporting is based on the presumption of ongoing economic growth and is seasonally adjusted. In tracking payroll employment for example, the assumption is that if a reporting company doesn't report, it is still in business, so the government will impute what they think would have been reported. They theorize that any jobs lost through companies going out of business generally are more than offset by jobs being created by the companies that haven't reported.

TGR: Isn't it a zero-sum game, then?

JW: It's more than a zero sum. They end up adding maybe 200,000 extra jobs per month that don't exist. The last time the government went back to benchmark its numbers, they found that they'd underestimated the decline by something over a million jobs by the time they published the benchmark revision. They've announced that the benchmark revision for March of 2010 (to be published with the January 2011 payroll numbers) will be a downward adjustment by something like 370,000 jobs. The point is that if you put those numbers in you end up with a much weaker employment picture than popularly gets reported.

TGR: If we add those numbers, where does unemployment stand?

JW: This is the payroll survey; unemployment is a separate number from the household survey. If you totaled up all the people who think they're unemployed you'll come up with a much higher number than the government reports but that's because of definition. The government publishes six levels of unemployment. To be counted as unemployed by the government's U3 headline number, you have to meet several criteria in addition to being out of work: you have to want a job, must be willing and able to work, and must have actively looked for work in the last four weeks. On that basis, the Bureau of Labor Statistics works out the unemployment rate.

The problem is that people who can't find jobs where they live give up looking even though they're still willing and able to work. The government counts these as "discouraged workers" if they've looked for work in the last year and adds them into a broader measure. The government's broadest measure, U6, includes the discouraged workers as well as those who are marginally attached to the workforce, such as people who take part-time jobs because they can't get full-time jobs.

TGR: How do the unemployment figures vary from level to level?

JW: The official number at the U3 level is around 9.8%. The U6 level is up around 17%. Adding in my estimate of long-term discouraged workers gets you up to around 22%. That startles people because they remember hearing that unemployment hit about 25% during the Great Depression. Estimates of unemployment in the Great Depression were all done after the fact, because the government didn't start surveying unemployment until 1940. The estimate for 1933, which is viewed as the worst year of the Great Depression, was around 25%—and that was in an environment where 27% of the population worked on farms. A lot of people went to live with relatives and help on their farms. Because today less than 2% of Americans work on farms, I think a comparable number for the Great Depression would be the non-farm unemployment estimates—which hit about 35% in 1933. In terms of historical comparisons, my 22% range may be the worst of the post-WWII era, but it's not at a Great Depression level at this point.

TGR: Getting back to your economic outlook, what else do you foresee in 2011?

JW: Eventually, the continued economic decline will be recognized officially, but people will be talking about the second leg of a double-dip before it gets any official recognition. I don't see any economic growth ahead. In fact, I see a pretty bad further contraction. For instance, as bad as it's been, if you look at housing starts, the housing market never really had any bounce-up from the stimulus (except maybe a little bit in the home sales numbers tied the expiration of tax credits), and it's actually started to turn meaningfully to the downside again. That's bad for the banking system. It's not good news for anyone.

The problem is we have a solvency crisis and an economic crisis that are ongoing simultaneously. If you go back to when the crisis broke in late 2007 and the panics in 2008, Treasury and Fed actions were aimed at preventing a systemic collapse. They have not solved the banking system's solvency issues. Short-term credit to consumers and business from banks is still declining, both month-to-month and year-to-year. That's a sign of a banking system in trouble. In the last five or six months, there may have been a bit of an uptick in M3, but it looks like that's turning down again. That's another sign of an unhealthy banking system.

Weaker-than-expected economic activity not only will intensify this systemic solvency crisis, but also has all sorts of other implications. It will increase the federal budget deficit, with a lot more spending than people have been anticipating. At the end of the year, for instance, we saw some of this in more bailouts for the unemployed. Going forward, we easily could see some potential failures in a number of states and municipalities that are in serious trouble. I suspect that the Fed and the Treasury will continue to create whatever money they have to spend to prevent a systemic collapse, but the process builds up inflation, and we're already beginning to see that.

TGR: Last year, many companies managed to strengthen their balance sheets and cut a lot of costs. Many are now able to self-finance. In addition, the Dow increased 10% or 11% over 2009. How do you reconcile those rather positive economic indicators with what you see happening?

JW: Most of that is triage as opposed to healthy economic growth. Businesses are always creative and have a lot of flexibility on what they can do to enhance their finances. Cutting employment through the muscle into the bone is not necessarily a long-term healthy approach, although the way they handle the accounting can produce a short-term boost and some gain in the stock price. Keep in mind that corporate America has a planning horizon of the next quarter. Both corporate America and the banking system use all sorts of accounting gimmicks.

When I see strong revenue growth and healthy profits without operations being lopped off and without one-time charges, I'd be willing to consider something more is going on than I'm looking at. It's similar to what the Fed's up to, with Mr. Bernanke now pushing his second version of quantitative easing. He's saying he's going to stimulate the economy by creating inflation. Higher inflation often accompanies strong economic growth, but it is the economy-generating inflation—not the other way around. If the economy's booming and demand is strong and supply's not keeping up with the demand, you can have inflation—in many ways a healthy inflation, if there is such a thing.

But inflation also can be driven by currency and commodity price distortions. Higher gasoline prices translate into higher inflation for the consumer. But it's not because of strong oil demand or strong gasoline demand. It's due to weakness in the dollar and the Fed's policy trying to debase it. You can see it coming in other commodities, and in food. We're going to see higher inflation down the road that is a result of a weaker dollar—not a strengthening economy. All the Fed can do with the inflation they're creating is push an ultimate day of reckoning into the future a little bit. (For a more complete picture of how dollar-debased inflation in commodities evolves, check out his Gold Report interviews of April 30 and August 6, 2010—Editor.)

TGR: Would you agree that the correct approach is for the Fed to do what it needs to do to avoid the collapse of the banking system even with the unfortunate outcome of creating this inflation?

JW: There is no happy exit. The correct approach would have been to avoid the circumstance in the first place, but it's the nature of the political system always to take a gain in the immediate future regardless of the expense over the long term. There have been many years of conventional wisdom that the deficit and the U.S. dollar don't matter. They both do. There comes an eventual day of reckoning and that's what we're facing.

I think they'll continue to do what they're doing, and I can't blame them. They have a series of devil's choices. We've gone too far to bring things into balance.

TGR: What might have been done differently to avoid this mess?

JW: The current circumstance could have been avoided decades ago with prudent management of the government's finances. Now, given the choice between immediate systemic collapse and printing more dollars, I likely would do what the government is doing, because printing money at least buys a little more time.

If I had control of the system, however, in an effort to right fiscal conditions I would attempt to slash spending, particularly making the necessary cuts in the so-called entitlement programs. I do not see this as politically possible. On the other hand, the negative political and social consequences, the short-term damage to the economy, and the public's financial pain could not be worse than what would happen with a hyperinflation or outright systemic collapse.

TGR: Damned if we do, damned if we don't.

JW: The only other option, although I just don't see it happening unless as I' just suggested—and it's a big unless—is to bring the federal deficit under control. I'm talking about the true deficit, of course, not the cash-based deficit we see month-to-month and year-to-year in the popularly published numbers. We're seeing ongoing annual deficits of $4 trillion to $5 trillion. That's beyond sustainability. The government can't raise taxes enough to bring the GAAP-based deficit under control. We'd still be in deficit if they took 100% of people's wages and salaries and 100% of corporate profits. Short of slashing Social Security and Medicare—where we have problems with long-term unfunded liabilities and present value of same—and reversing the trend toward funding a lot of social programs on the backs of taxpayers (including increasing numbers of aging baby boomers), there's no way they can balance the budget. There's no political will whatsoever in Washington with the current administration or any recent administration to bring that under control.

My views haven't changed since we last talked. The ultimate result here is the government printing money to meet its obligations. The Fed effectively is funding the government's borrowing. But as the economy continues to weaken, as the deficit worsens, as the Treasury funding needs increase, quantitative easing and monetization of U.S. Treasuries will have to increase. We're going to see more and more foreign holders of dollars sell their dollars. I think there's high risk in the next year of a panicked sell-off, a panicked dumping of USD-denominated paper assets. All of that will cause the Fed to continue to flood the system with liquidity, to buy up unwanted Treasury debt and stimulate inflation. As people increasingly don't want to hold the currency because of the inflation, we'll start to see higher inflation that quickly can evolve into hyperinflation.

TGR: When do you anticipate that major rush to sell dollars?

JW: I can't tell you for sure that's going to happen, but if I'm right about what's happening with the economy and how the Fed will respond—with more, not less, quantitative easing—the general response in the world markets will be to dump dollars, and there is high risk of that in the year ahead.

TGR: Will anything specific trigger that rush?

JW: It could be anything. Something like that's almost impossible to predict. It probably would be a confluence of factors.

TGR: You indicated that we'll start to see hyperinflation when enough people don't want to hold dollars because inflation's eroded their purchasing power. Any idea when that will be?

JW: We could see hyperinflation breaking in the next year or two. I put an outside date on it of 2014. I'm talking about a hyperinflation in which the USD becomes virtually worthless, which means all kinds of unstable markets, unstable times politically over the long haul. (Check out what John has to say about hyperinflation. His website still carries his original Hyperinflation Special Report, published in 2008—after the Bear Stearns implosion but pre-Lehman, pre-TARP and pre-Obama. John revised and republished it in December 2009, and updated it again last year—Editor.)

As an economist looking at the broad trends—I'm not an investment advisor—people in a USD-denominated environment will need to try to preserve their wealth and assets and protect the purchasing power of the dollars they have. That means holding some physical gold, physical silver, getting some assets outside the U.S. dollar. I still like the Australian dollar, Canadian dollar and Swiss franc, and I think they will come out of this relatively unscathed versus the USD. Over the long haul, gold really is the preeminent asset, with a history of holding its purchasing power over time.

TGR: Looking to another distressed currency for a moment, what do you make of the Chinese government coming forward to essentially become the creditor country for the European governments?

JW: I was never particularly fond of the euro. The Bundesbank was still afraid of inflation due to the horrors of the Weimar Republic inflation and all the politics that followed for decades after that. I didn't think it would work well to try to combine into a single currency the fiscally conservative policies of Germany—the major trading power there—with the liberal policies of countries such as Italy or Spain or France. I think the problems they've run into were foreseeable.

As for extending credit to Europe, from China's standpoint the U.S. is the elephant in the bathtub. China knows what's happening, and certainly has expressed it pretty clearly. They have a rating agency that has detailed the problems with the USD and how the outlook for U.S. creditors is dimming. If I were China, I'd also be looking to do something like this to try and get out of dollars as much as possible.

TGR: A moment ago, you described gold as the preeminent asset. You've cited some interesting statistics about gold relative to the Dow over the last seven consecutive years. Would you elaborate on that?

JW: Let me start by saying that although I have a number of gold bugs as clients and I love gold bugs, I'm not one myself. As I've indicated, I'm just an economist looking at the broad picture. From that perspective, gold is probably the single best asset to help people ride out the storm, based on what we're facing, and I would contend that there's been an increasing view from that perspective in the global investment community over the last decade.

I hadn't realized it until I was putting together some year-end numbers and noticed that every year since 2004, gold has outperformed the Dow Jones Industrial Average in each year. I'm not talking a cumulative number, but year-to-year. We've certainly seen a lot of volatility in gold prices, but gold hasn't had a negative year, while the Dow was down 33% in 2008. Wall Street pooh-poohs gold as a fringe investment, but its performance suggests quite the contrary. It's one of the historical world-class assets, and over the millennia has been fairly consistent in terms of preserving purchasing power.

TGR: In fact, many people call gold "the insurance."

JW: It is. Insurance against a financial Armageddon. Gold's over $1,400 an ounce as we speak. When it gets up to $5,000 people will say, "Oh my goodness. I bought it at $1,400. I can sell it at $5,000 and make a lot of money." That profit may be there, but the way to look at gold is that it anticipates the inflation ahead and preserves the purchasing power of your paper assets. Even if gold gets to $100,000, it's not that you've made $98,600 profit, it's just that you still have the purchasing power you did with your $1,400 gold.

TGR: You're looking at gold as a wealth preserver. Do you see any way to accumulate or increase wealth during these inflationary times?

JW: People always see opportunities and, again, are very creative. But I see this as a time to batten down the hatches, buy your insurance and lock in your wealth and assets in terms of purchasing power. If you come out of the storm, you'll have some of the greatest investment opportunities that anyone will have ever have seen. If you can get through the difficult times with your assets and maintain liquidity, you'll be able to take advantage of those opportunities.

Along the way, unusual circumstances certainly will arise. You can expect a lot of volatility; but, generally, you'd also expect gold to at least maintain its value so that you could take advantage if an unbelievably good opportunity came along.

TGR: Any final thoughts you'd like to give to our readers?

JW: Well, as I indicated, from an investment standpoint, you have to look at preserving wealth and assets. Once you're beyond the point of healing the system, you have to look at the personal level—protecting yourself, your family. I'd also build up a store of goods that could carry your family for a couple of months, stuff that you could recycle or roll over, because there's danger of disruptions to the food supply chain and grocery stores; for example, if a hyperinflation breaks.

Regardless, I see very difficult and dangerous times ahead. It's going to be very painful. If there were a way I thought the government could work its way out, I'd be advocating it strongly. But I just don't see that as a political practicality.

TGR: Thanks. This has been very enlightening.

Walter J. "John" William, is a Baby Boomer who has been a private consulting economist and a specialist in government economic reporting for 30 years, working with individuals and Fortune 500 companies alike. He received his AB in economics, cum laude, from Dartmouth College in 1971 and earned his MBA from Dartmouth's Amos Tuck School of Business Administration in 1972, where he was named an Edward Tuck Scholar. John, whose early work prompted him to study economic reporting and interview key government officials involved in the process, also surveyed business economists for their thinking about the quality of government statistics. What he learned led to front-page stories in the New York Times and Investor's Business Daily, considerable coverage in the broadcast media and a joint meeting with representatives of all the government's statistical agencies. Despite a number of changes to the system since those days, he says that government reporting has deteriorated sharply in the last decade or so. On the bright side, it keeps John and his economic consultancy, www.shadowstats.com , in the limelight. His analyses and commentaries have been featured widely in the popular domestic and international media.

Want to read more exclusive Gold Report interviews like this? Sign up for our free e-newsletter, and you'll learn when new articles have been published. To see a list of recent interviews with industry analysts and commentators, visit our Expert Insights page.