The Gold Report: Your investors' report last week was entitled, "Orwellian Currencies: Weakness is Strength." Could you please explain?
Don Coxe: In his classic book, "1984," George Orwell's Big Brother rules society with three slogans: "War is peace. Freedom is slavery. Ignorance is strength." I coined the slogan "Weakness is Strength" to sum up the idea that a weak currency creates a strong economy. But it has to be weak like Goldilocks' porridge: Weak enough so that domestic industries can still sell products abroad, but not so weak that people dump government bonds and cause a financial crisis, which is the situation that threatened the Eurozone when the euro went south 18 months ago.
"Investors who believed that gold was doomed to collapse back in 2005, 2006 and 2007 were totally destroyed because gold soared to new, all-time peaks."
After the fall of the Berlin Wall and the implosion of Communism, there was a general consensus that capitalism had become triumphant. At the end of the last decade, a Democratic president proclaimed the end of the welfare state and the end of big government. The idea was that central banks would only be temporarily needed in the face of a crisis, because the basic economy is strong enough to stand on its own. But in 2008, the financial collapse was blamed on the private sector. Actually, it was the intersection of corrupt politics with bad banking practices that caused the crisis, but that was the way the media narrative was played out.
TGR: Who is in charge?
DC: An elite group of central bankers are in weekly communication with each other on a first-name basis. That's why when the crisis came, everybody knew whom to phone. This elite group of international bankers puts up with politicians, whom they regard as a mixed blessing at best, and a curse at worst, and certainly not as smart as the bankers. This elite is comparable to the great 19th-century diplomats who ran global affairs prior to World War I, managing things pretty well until it all blew up in the war.
Now the central bankers are saying, "Don't let currencies get too strong." It started with Japan. The yen reached an all-time high last summer. It was after the nuclear crisis, and Japan was in deep recession. It has the worst demography of any country on earth, and it's being harassed by the Chinese. A new premier decided to drive down the value of the yen by printing more money. Consequently, hedge funds got rich by shorting the yen, further driving down its value. The Nikkei rallied and Japanese companies started reporting bigger profits, with great expectations ahead. In Japan, weakness is strength.
Weakening currency works as monetary policy until it kicks off runaway inflation, which is what happened after Venezuela devalued the bolivar by 47%. Inflation shot into double digits. It is hard to use monetary policy to cook the not-too-hot, not-too-cold porridge. The goal of the central banks is to manipulate interest rates to make sure that weakened currencies do not become too expensive inflation-wise. And it is this dilemma that moves gold.
TGR: Why hasn't inflation shown up in the Western economies?
DC: Advanced technology means that the supply of consumer goods can keep expanding as prices fall. We've had technological booms before, but nothing as powerful as the current boom, in which the improvement in technical performance is exponential.
The North American demography is deteriorating as the baby boomers age. Older people have most of the stuff that they need and are just trying to hang on to their savings.
Also, we have the freest trade since the glory days of the British Empire. We are still benefiting from the opening of free trade with the creation of the World Trade Organization, although the low hanging fruit has been harvested. In other words, this could have been the best of all times for the global economy.
TGR: What is going on?
DC: Milton Friedman said that proper monetary policy will guarantee reasonable economic growth without inflation, for which he won the Nobel Prize, which shocked the Keynesians. But at some point, printing money is going to lead to inflation. It was frustrating for gold enthusiasts when the Bank of Switzerland expanded its monetary base by 700% in a mere two years. At the moment, the Swiss are applauding their central bank for weakening the currency. It makes the Swiss watchmakers more competitive, and the Swiss consumers are not traveling to France to go shopping.
TGR: How are the devaluations affecting the dollar?
DC: The dollar is benefiting, because the United States is importing less energy. Energy prices are strong everywhere in the world, except in the United States and in Qatar, where oil and natural gas are cheap.
The dollar is still the world's No. 1 currency. The euro, somewhat surprisingly, is No. 2. But there is an election coming up in Italy in a week, and talk that Silvio Berlusconi could come back shows that Italian politics are unstable.
"Unlike every other commodity, the amount of new gold produced is virtually irrelevant to the price because it only adds about 2–3% to the total existing supply of gold."
The dollar has long been the international currency of first resort and last resort. Some 85% of currency trades are done with the dollar on one side of the trade. Of course, the euro is a currency backed by no country, no tax system, no army and no navy. It's backed by theory, a theory that Europe has been violating virtually every month for the last five years by creating deficits. And the dollar benefits. We were told in the last election campaign that the Chinese are financing the U.S. deficit. That is a myth. In fact, the Federal Reserve has purchased about two-thirds of the increase in the national debt.
TGR: Does that mean that central banks around the world are not holding their reserves in dollar denominations as much as they were previously?
DC: As a percentage of their assets, the answer is absolutely yes. But because central banks are expanding their monetary bases, the dollar's share of the total pile of accumulating paper money is shrinking. That does not yet mean that there is net liquidation of dollars, and central banks are dramatically increasing their consumption of gold. Of course, as a percentage of the total monetary supply, the rise in gold consumption is tiny.
TGR: So when you say central banks are increasing their gold holdings, how does that impact the exploration and development sector for gold?
DC: The appetite for gold exploration and development is a complete contrast to five years ago—years in which the price of gold rose every year. Investors do not believe that companies will be able to find and develop gold mines at a reasonable cost because the gold milling return is often less than 1 gram per ton (1 g/t) of ore. There is a growing fear that if the miners develop technology to extract more gold, governments will jump in and make life miserable for them. Or that radicals will stop production because of alleged pollution, destruction of water or just plain because the miners are capitalists. The flow of capital for developing new gold mines has been choked off over unprecedented price increases. The situation is a total disconnect.
TGR: Are you saying that there's a perception that gold has reached a price ceiling?
DC: People are wondering where the next price floor is, which is a different type of concern. When gold was moving up, the debate was about how high it might go. Now investors are afraid that gold will collapse. Investors who believed that gold was doomed to collapse back in 2005, 2006 and 2007 were totally destroyed because gold soared to new, all-time peaks. Is gold an animal that has to keep growing or die? I don't believe that, but we have no record of a stock market that's gone up 12 straight years. And if a stock market that had gone up for 12 straight years sagged back by 15%, would it be reasonable to believe that equities are bad investments and we should all move into treasury bonds?
TGR: Typically, gold was treated as a hedge against inflation and uncertainty. Is it still reasonable to look at it as a hedge?
DC: It's a hedge against inflation for reasons that in the past we were told were inevitable, but which have not yet happened. You would think that a person who drinks a fifth of whiskey a day and smokes three packs of cigarettes a day is not going to live as long as a normal person. But, suddenly, he is blowing out the candles on his 75 birthday cake. And you say, "This is not medically possible!" It is beating the odds, but at some point, it is going to catch up with the smoker. There simply is no record of huge expansions of the monetary base, huge expansions of government deficits, the inability of politicians to manage and the inability of economies to grow fast and mop it up that don't lead to inflation.
"This is the worst trading situation I have ever seen at a time of rising gold prices."
The supply of money relative to the total GDP is now the greatest in human history, and it keeps expanding relative to our actual output. This will lead to inflation. Will it be next year? In five years? Who knows? If you hand out free tickets to a rock concert, you may not drive down the price of the best seats, but if fans believe more than half the seats will be given away at the door, you can bet the promoters will have trouble selling tickets. And that's eventually what's going to happen to paper money.
TGR: The corporate sector is sitting on trillions of dollars and mostly non interest-earning reserves. So why isn't some of that trickling down to the junior gold explorers?
DC: There are not trillions of dollars sitting in the accounts of gold mining companies. The big gold mining companies who have cash need it because they've committed themselves to building expensive, new mines, which when completed will add an exiguous supply of new gold relative to the current supply. Unlike every other commodity, the amount of new gold produced is virtually irrelevant to the price because it only adds about 2–3% to the total existing supply of gold.
The "excess" corporate cash is an argument for buying gold, because that cash is land-locked. It cannot be brought back into the country without being taxed. Big hedge fund managers with assets in the Caribbean do not have to pay taxes on their income as long as they do not repatriate the money back to the U.S. This is one of the ways George Soros got so rich. He does not lead an extravagant lifestyle, and he became a billionaire by leaving his money offshore in the Caribbean where it could grow uninhibited. Most of Apple's cash is in foreign domains. But after adjusting for the tax basis, there is not much loose cash in Cupertino. And after adjusting the corporations' balance sheets for their real pension fund liabilities, the corporate sector is not really awash in extra financial resources.
TGR: What should gold investors do?
DC: As a director of a small-cap gold mining company, I understand the plight of the small exploration companies. This is the worst trading situation I have ever seen at a time of rising gold prices. Something is wrong with this story. Either it's going to turn out to be a sensational buying opportunity, or there will be a deflationary depression and even printing money will not work. I do not really believe that deflation is in the cards, but I also didn't know that we were going to get a man on the moon.
TGR: What is the significance of the current situation with the debt ceiling?
DC: After adjusting the U.S. national debt to account for all the bonds held in trust accounts, our debt/gross domestic product (GDP) ratio is close to that of the scary European countries. Our debt is growing much faster than Europe's relative to our GDP. If the euro doesn't bomb out in the next couple of years, it may turn out to be a strong currency relative to the U.S. dollar. By the end of this decade, the U.S. fiscal situation could degenerate to Spanish or Italian proportions, although certainly not to Greek proportions. By the way, financial experts who harp on Greece in their oratory destroy their own credibility. It is best to compare the U.S. economy with real economies not built on fraud, and that is Spain and Italy, both of which are models of where the U.S. will be at within five years. The Spaniards and Italians are doing a better job of dealing with their debt by far than the United States is.
TGR: Is international capital fleeing from North America?
DC: I don't think international capital is so much fleeing from North America as it is trying to find some places where it can get a better return. There's no question that in some cases, it's buying assets in emerging countries. "The Scream" is not one of the world's greatest pieces of art and yet it recently sold for an all-time record price at auction: buying art is just a place to bury cash.
TGR: Maybe "The Scream" will appreciate! Thanks for your time.
DC: You are welcome.
Read Don Coxe's ideas on energy investing here.
Don Coxe has 40 years of institutional investment experience in Canada and the U.S. As a strategist and investor, he has been engaged at the senior level in global capital markets through every recession and boom since the onset of stagflation in 1972. He has worked on the buy side and the sell side in many capacities and has managed both bond and equity portfolios and served as CEO, CIO and research director. From his office in Chicago, Coxe heads up the Global Commodity Strategy investment management team, a collaboration of Coxe Advisors and BMO Global Asset Management. He is advisor to the Coxe Commodity Strategy Fund and the Coxe Global Agribusiness Income Fund in Canada, and to the Virtus Global Commodities Stock Fund in the U.S. Coxe has consistently been named as a top portfolio strategist by Brendan Wood International; in 2011, he was awarded a lifetime achievement award and was ranked number one in the 2007, 2008 and 2009 surveys.
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