-->The Good, The Bad, The Ugly

The Daily Reckoning

Paris, France

Tuesday, 26 May 2003


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*** Deflation fears...

*** Dollar sinks...

*** Wall Street closes...


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Deflation, deflation, deflation.

The word is getting a workout. A few years ago, almost no one
had heard of it. Now it seems to come up on every financial
page...and even at polite dinner parties. People say the word
without embarrassment...and feel no need to apologize after if
comes out. They don't even have to explain it. Everyone
knows what it is.

"Deflation fears" are driving up bonds (and driving down bond
yields) say the news reports. Ten-year treasuries rose on
Friday; yields fell to 3.30%. So, if you buy a $10,000 bond
you'll earn the handsome sum of $330 dollars each year as your
reward for lending the government money. This, by the way, is
the same government that is promising to make the $10,000
worth a lot less in the future than it is now. The most
recent talk has the Fed"targeting" an inflation rate of
around 3%.

Hmmm...you earn 3% in yield while you lose 3% to inflation?
And that's if the Fed hits its target. It might just as well
end up a little wide of the mark...with inflation, say, at 5%
or 10%. Why would anyone who is not a neo-con...that is to
say, anyone who is capable of thinking straight...want to buy
bonds on those terms? U.S. treasury bonds have become an
investment where the risk/reward ratio seems so steeply tilted
towards the risk side that only an economist would want them.

Almost everything looks better. Euro bonds pay twice as
much...and the euro is rising. Chris Wood of"Fear and Greed"
recommends"nearly every traded currency in the world, with
the exception maybe of the Philippine peso" over the U.S.
dollar.

And yet, to the Japanese, a 3% yield on dollar holdings looks
pretty good. The equivalent yield in Japan is just 0.535%.
Or 'effectively zero.' But while they earn nothing on the
yield, the price of things falls...so they get their profit
from deflation.

The Japanese are now buying U.S. bonds. In fact, they're the
biggest buyers. They are trying to keep the dollar up against
the yen, say the analysts. Even in a slump, Japanese exporters
sell 30% of their wares to the U.S. and need to keep Americans
buying.

They also hope to make money from their investments in the
U.S."Substantial further disinflation would be an unwelcome
development," said Alan Greenspan last week. But that is
exactly what the Japanese are betting on.

"Our own situation is strikingly similar in some ways to that
of Japan a decade ago," Paul Krugman elaborates."Like Japan
circa 1993 or 1994, the United States is now facing the
aftermath of a huge stock market bubble - the Nikkei and the
Standard and Poor's 500 both tripled in the five years before
their respective peaks.

"Also like Japan, we face a problem not of sharp downturn but
of persistent underperformance - an economy that grows, but
too slowly to prevent rising unemployment and falling capacity
utilization.Whatever reassurances Mr. Greenspan may offer, the
staff at the Fed is very worried about a Japanese scenario for
the United States."

The effect of persistent underperformance was deflation.
Prices have in Japan fallen about 1% per year for the last 7
years. Bond yields have dropped to near zero and stayed
there.

If America follows the Japanese example, bonds will rise
further and buyers will look like geniuses. If not, they will
look like the rest of us.

Over to Eric Fry, back in New York:


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Eric Fry writing from Wall Street...

- US financial markets hung out the"Closed" sign yesterday
in observance of Memorial Day.and, like most Americans, we
New Yorkers fired up our barbecues, despite the constant
"hiss,""hiss,""hiss" of a dreary, cold rain dousing our
Weber grills.

- Someday, we imagine, warm weather will return to New York.
And someday, we imagine, our economy will again bask in the
warm glow of economic growth. But an unseasonable and
uncomfortable chill continues to linger over the national
economy.

- Happily, the stock market's pyrotechnic display is throwing
off a little heat, while also creating an entertaining
diversion for the lumpeninvestoriat. As long as share prices
rise, investors may indulge in all manner of happy fantasies,
like the soothing notion that a weakening dollar is good for
the economy.

- It's true, of course, that a little dollar devaluation --
like a little cocaine -- provides a little pick-me-up. But
overindulgence is as certain as it is destructive. As the
dollar's"manageable" devaluation devolves into something
less manageable, the"little pick-me-up" becomes a"big
downer." Eventually, foreigners sell their dollar-denominated
assets in order to stash their capital in a currency that is
not depreciating day after day. Dollar selling begets further
dollar weakness, which begets further dollar selling.and
that's not a pretty picture. The greenback may be much closer
to such a dangerous"tipping point" than most Americans
imagine.

-"With America more dependent on the rest of the world for
foreign capital than at any time in the past 50 years, any
disruption in that supply is cause for concern," the
Financial Times reports."This year both the US current
account and the US budget could be in deficit by as much as 5
per cent of gross domestic product, representing a material
proportion of the rest of the world's savings. Indeed,
foreign investors' willingness to supply America with capital
at yields of less than 4 per cent is what has prevented the
country from plunging into a big recession."

- But how much longer can we expect our foreigner creditors
to buy bonds yielding 4%, when those bonds are priced in a
currency yielding minus 20%?

-"The non-U.S. portion of the world has a vote on dollar
interest rates," Jim Grant observes in a recent Forbes
column."Because the U.S. consumes much more than it produces
and owes abroad much more than it owns abroad, torrents of
dollars pour into the world's payment system. The holders of
these dollars have Bloomberg terminals, too, and some fine
day they might wake up and sell bonds. Who could blame them?"

- Although we Americans have been running a current account
deficit for a decade, and counting, we never seem to lack for
willing creditors.

-"But there are a few reasons the deficit could be harder to
finance this time around," the Financial Times ominously
asserts."First, the US investment proposition has changed.
Three years ago, overseas capital rushed to fund a private-
sector, technology-inspired productivity miracle. Now America
needs twice as much capital from abroad to fund a large and
rising public-sector deficit that has arisen as a result of
President George W. Bush's tax cuts and the war on
terrorism.At the very least, foreign investors may be keen to
change the terms and conditions under which the world
supplies America with capital."

- In other words, interest rates may rise to compensate for
the ever-present risk that the dollar's value may fall. And
it is possible, we imagine, that rising interest rates --
triggered by a falling dollar -- could exert an un-bullish
influence on share prices.


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Addison Wiggin back in Paris...

***"For most of the 20th Century gold has been under
assault," writes our fearless leader, Bill Bonner, in an
introduction to a new 3-volume set called The Case For Gold.
"A war against it has been waged for the last seven decades.
The struggle has gone back and forth... with gold gaining
ground in some years, losing it in others. Never has there
been any doubt about the final outcome.

"No paper money has ever endured over the long run... nor has
gold ever disappeared, or ever lost value against paper money
over an extended period. But something extraordinary happened
in the last two decades of the 20th century... something that
never happened before: For a period of 20 years the Midas
metal retreated... while paper currency, primarily the U.S.
dollar... rose in value against it. As a result, gold fell
far from grace in the eyes of governments, politicians,
bankers, economists, Wall Street and Main Street as well.

"But there was a time when Presidents, bankers, economists
and philosophers spoke of gold with respect and awe, not just
as money, but also as a protector of wealth and freedom.

"Paper money is a great aid to politicians. It makes it
possible for them, said President Herbert Hoover, to
confiscate 'the savings of the people by manipulation of
inflation and deflation.'"

During The Great Depression, those who wanted a safe harbor
for their wealth, turned to gold. Now it appears that
deflation, secular recession, runaway inflation and perhaps
another depression are on the horizon. And gold once again is
coming to the center of the financial arena.

With these rapid changes in mind, we publish a special two
part series:"The Good, The Bad, The Ugly" by chairman of
Lion's Gate Films Frank Giustra... below...

Enjoy,


Addison Wiggin

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The Daily Reckoning PRESENTS: If the current global economic
situation were a movie, it might be titled"The Good, The Bad
and The Ugly"...


THE GOOD, THE BAD, THE UGLY
by Frank Giustra


If you think you have seen this movie before, you are right,
since this movie has played time and time again throughout
history. Other than regular changes to the names of the
currencies and the nations, the movie usually ends much in
the same way.

Our protagonist, gold ("The Good"), prevails in the end,
while as the antagonist, the U.S. dollar's ("The Bad") fate
is sealed from the start. And what would a movie be without a
sidekick, in this case the American Government ("The Ugly"):
an often-misunderstood character whose unpredictable actions
inevitably have an impact on the outcome of the fortunes of
the two central characters.

Unfortunately, the lesson in this story - the US dollar's
unfortunate fate - seems lost with most people today.

There are a multitude of forces at play behind the current
bull market in gold. So, I think it misleading, that so much
attention is given to the daily gyrations of the gold price,
which in turn takes focus away from the true nature of the
forces behind this bullish trend.

Commentators, both bulls and bears, are quoted daily on the
reasons for that particular day's price move. Invariably,
most attribute the recent moves to either the fear of a messy
war with Iraq or the dissipation of those fears. My reaction
to all this daily noise - is to ignore it. We are in a
secular bull market in gold that is driven by macro-economic
events that have little to do with the immediate Iraqi
situation. This trend will continue for a number of years,
and while the daily ups and downs of the gold price may make
bulls suffer anxiety and give the bears opportunity to
declare the end of the bull market on a regular basis -- the
trend is clearly up.

Remember, every bull market, whether it's in stocks, bonds or
gold,"climbs a wall of worry" in the early stages and it
never goes straight up. In addition, gold is especially
volatile given its lack of liquidity compared to other
financial assets. As an example, witness the 1970's gold
market, which I believe bears many similarities to the
current market. It took ten years of dramatic ups and downs
before it eventually climaxed with an $800 gold price in
1980.

Gold is the chicken soup of all economic maladies that ail
the world. It has taken many years and plenty of abuse to the
system to create the necessary environment for the major gold
market we are now seeing. The gold price will continue to
move higher as the effects of that abuse are recognized and
fully understood. The corrective process will be beyond what
most people are prepared for. In the end, the standard of
living most Americans took for granted will be lowered
significantly. The structural deterioration of the system is
the end result of such things as an aftermath of a stock
market bubble, unprecedented high levels of public and
private sector debt, and a U.S. currency whose meteoric rise
and subsequent abuse allowed it to permeate into every
financial corner of the world.

So although factors such as declining primary production
(2002 gold production fell for the first time in seven
years), ever increasing de-hedging policies by gold producers
(hedge books contracted by 423 tonnes in 2002, almost three
times as much as the previous year), a forty-year-low
interest rate environment and its re emergence as a preferred
asset class (with the underperformance of financial assets,
gold purchases for investment purposes more than doubled from
2001 to 2002), will continue to help the gold price move
higher, gold's status as a currency and store of wealth will
be the driving force behind its long-term upward trend. Since
gold and the dollar have a historical high inverse
correlation, the degree to which the importance of the U.S.
dollar waivers or falls, will have a corresponding positive
effect on the price of gold.

I am fairly sure that the folks who brought us such religious
ideas as Judaism, Islam and Christianity, did so with the
best of intentions. The eventual success of these religions
made them so powerful, that the temptation to abuse them was
too much to ignore. Similarly, the folks that created the
concept of fiat currencies also had the best of intentions as
they attempted to smooth, and perhaps even eradicate, the
business cycle. But, as with religion, the tremendous success
of the currencies, which have represented all of history's
global powers, also begged for abuse.

For a number of reasons, the U.S. dollar has achieved such a
dominant status as the premier global reserve and transaction
currency, that its abuse as a tool to exercise power goes
barely noticed.

By all measures (as against other currencies and commodities)
it is evident that the dollar is loosing ground..but why?
There are many reasons, but in general terms, abuse by U.S.
policy makers and citizens alike, allowed it and the system
backing it to get so corrupted, that spooked foreign dollar
holders began switching into other currencies and gold.

Let's recap in more detail - the U.S. was the recent host to
the greatest stock market bubble in history, which burst
three years ago. Even so, like the villain in a B movie, the
U.S. stock market continues to resurrect no matter how many
fatal blows it receives by way of bad news. Consumers,
government and corporate debt have grown to levels totaling
well over $30 trillion with only corporations showing any
recent signs of restraint. Consumers, the worst offenders,
continue to pile it on - having increased their debt load by
500% in the last twenty years and are continuing to borrow at
a rate which is ten times faster than Gross Domestic Product
growth. For its part, the government, having doubled its debt
load to $6.4 trillion in the past ten years, borrowed an
additional $750 billion in the past eighteen months alone.

Also, short-term interest rates are at forty-year-lows,
allowing for nothing more than further speculation in stocks,
bonds and real estate, while the widening real interest rate
differentials are potentially disincentivizing foreign
purchasers of U.S. government debt. Throw in America's
aggressive foreign policy (which will help push the federal
deficit to almost $500 billion this year), the Fed's threat
to print money as a means to avoid deflation and an annual
current account deficit representing 5% of Gross Domestic
Product - it doesn't require much imagination to see why
foreign holders of dollars may soon look to the exits.

Let's look briefly at all these factors, starting with the
stock markets. Even though the bubble burst three years ago
and equities are off between 30% and 75%, depending which
exchange they are listed on, it's still hard to justify
current valuations. With the S&P 500 trading at thirty times
earnings it's hardly a steal.

Worse still, if one factors in the current reality of rising
energy, insurance and health care costs (which have all
increased dramatically), pension plan losses (once reality
replaces the current policy of reporting fictional gains),
excess capacity, lack of pricing power, declining consumer
demand and how all of these factors impact corporate profit
margins, the"E" part of P/E (price to earnings) forecasts
suddenly become suspect.

As in the last couple of years, after barely hitting recently
downgraded earnings, corporations are ratcheting down their
earnings guidance for the rest of 2003, and as usual the
analysts are ratcheting down current quarter market forecasts
and back loading the higher growth in the third and fourth
quarters. With economic indicators such as ISM (Institute for
Supply Management), factory orders, retail sales and initial
jobless claims worsening, I wouldn't be surprised if we don't
soon double - dip into recession, foretelling a further drop
in earnings.

So why are equity valuations so high? The Fed's continuing
easy money policy fuels the fire, I am sure. And for some
reason Wall Street strategists and economists continue to
retain credibility with their wacky market and economic
growth forecasts. But, I think it has more to do with a
change in investors' attitudes and perceptions. For years, a
pervasive media and the spin meisters - who know how to use
it, have shaped these perceptions. CNBC in my opinion is the
biggest purveyor of optimism in the market place, although
they are not alone. You would think it might be difficult to
consistently put a positive spin on an endless string of bad
economic data.

But by a combination of what appears to be selective emphasis
(i.e. no repetition or follow-up on bad economic news and
repeating the trivial stuff ad nauseam) and allowing
"industry experts" (who all have an interest in keeping
investors in the game) to comment and opine on the data, and
finally switching to sports and entertainment news on days
when the economic news is particularly bad, investors never
have a chance to do the right thing..and panic. Instead,
investors feel obliged to pile into overpriced stocks with
the tenacity of a pod of pilot whales beaching themselves.
As for CNBC, who knows, maybe its parent GE will recognize
this winning formula and license the format to foreign
territories suffering with sagging stock markets in need of a
boost.

Irrespective of all this hype, equities will inevitably come
down to earth. The effect this will have on the dollar will
be very negative, as approximately $1.5 trillion worth of all
U.S. equities are foreign owned. Consider what must be the
growing disappointment of, say a European, whose U.S. equity
portfolio may be down a nominal thirty percent or more, but
is actually down over forty percent in his home currency
terms.

At some point he will cut his losses.

That said, it is always difficult to predict short-term
market performance and with all the liquidity currently being
pumped into the system, it's quite possible that the U.S.
dollar will decline against the backdrop of a stock market
rally.

With regards to the debt situation, foreign lenders who own
over 40% of U.S. government debt, 23% of U.S. corporate bonds
and over 20% of mortgage debt must, by now, be waking up to
the fact that the U.S. is a nation of savings-deficient,
debt-hooked consumption junkies. Furthermore, it is governed
by an administration that is hell-bent on creating $1.8
trillion - according to the Congressional Budget Office (CBO)
- of deficits over the next ten years. It may end up even
higher as it looks as if current budgeting of U.S. Social
Security benefit costs will prove totally unrealistic. Just
two years ago the CBO projected a $5.6 trillion surplus in
the same period. One might think this kind of swing would
raise some eyebrows in the global currency markets.

But, if history provides any clue, it is that eventually
there should be a"tipping point", when the creditworthiness
of America will come into question. It is impossible to guess
when that day will come even though the cracks are beginning
to show. At best we will see a decade-slow deterioration of
America's creditworthiness accompanied by continued dollar
devaluation and, at worst, outright panic followed by an
Argentina-style (they also had a lack of domestic savings
when foreign lenders cut them off) dollar collapse.

There is no doubt that currently America is the most dominant
economic and military power on earth. Although the world has
seen many great powers come and go, including the Spaniards,
the French and the British, America's influence in all global
matters, whether economic, military, technological or
cultural, is a phenomenon the world hasn't seen since the
Roman Empire.

Sadly, the mistakes that brought about the economic demise of
all the past global powers are being repeated with impunity
by America's government and citizens alike. When confronted
with these historic similarities, most Americans will likely
dismiss the danger, convincing themselves that their current
superiority is deserved and permanent. They believe that
their system is so advanced and sophisticated that policy
makers will always manage to keep things under control.

Even when the system shows signs of strain; they all work
feverishly to spin the information such that the masses do
not panic. This game of confidence (or otherwise known as a
"confidence game") will continue until something gives. For
their part, the masses are happy for the reassurance, even
though their gut may tell them all is not well. Since most
people can only relate to their own lifetime experience, they
will believe when told that the current malaise is a run-of-
the-mill recession. Very little attention is paid to the fact
that the current system has structural flaws that have
deteriorated over the last three decades. These flaws are
worsening in an exponential fashion, and still we would
rather believe that this is a garden-variety recession that
can be remedied with the traditional tools of fiscal and
monetary policy.

It is becoming increasingly evident, to some at least, that
these policies are not working this go around. When a system
is overloaded with debt and over capacity and there already
exists a gross imbalance between consumption and production,
no amount of monetary or fiscal stimuli (which are meant to
inspire demand) will work. Conversely, it makes the situation
worse by fueling asset speculation and increasing public and
private sector debt.

Looking back, it is difficult to argue that, historically
speaking, America was initially a great experiment. The
American standard of living is the envy of the world and was
achieved by a combination of a political system that allowed
and rewarded success by anyone regardless of class, and by a
puritan work ethic that didn't exist elsewhere. Both these
characteristics held true for most of the 20th century and
started to deteriorate only in the last several decades. This
path to economic perdition was a result of an ever-increasing
societal shift from production to consumption, and by
transformation from a nation that was once the number one
creditor to the world to one of being the number one debtor.

Americans are holding on to their standard of living not as a
function of their productivity, but at the sacrifice of the
family unit (since it now requires both spouses working to
maintain a standard that forty years ago took only one), and
at the expense of their own future generations (as the result
of the increasingly heavy debt load), and at the expense of
the rest of the world (a function of its record and ever-
growing trade deficit).

How long the world's other 5.7 billion people will continue
to trade their products and standard of living for U.S.
dollars is anyone's guess, but I suspect that with the
Current Account deficit running at $500 billion per year (and
expected to rise to $600-$700 billion) and the U.S.
government's printing of dollars and issuing debt at historic
proportions, it won't be for long.

The ever-increasing government fiscal deficits are the result
of a system that refuses to sacrifice consumption while its
government embarks on a military adventure to reshape the
world in its own image. It has to be a historical precedent
that a debt-laden government goes to war and proposes to cut
taxes simultaneously. Keep in mind that the CBO forecast
mentioned earlier does not include the cost of waging a long-
term war on all that is anti-American.

Government deficits can only be satisfied by borrowing from
either its own citizens (an indirect form of taxation) or
from foreigners. Already foreigners own over 40% of the $6.4
trillion in government debt. Add to that the projected
accumulated deficit of at least $1.8 trillion - I believe it
will be a much higher number, given this year alone the
deficit could reach $500 billion - over the next decade plus
borrowing for other"capital expenditures" and the total debt
becomes a whopping number.

Then assume the same ratio of foreign holdings and it becomes
apparent that the U.S. will have a difficult time servicing
that debt, never mind ever paying it back in anything
resembling current dollars. Of course, the alterative
solution is to inflate the debt away by printing more
dollars, which is exactly what the Fed has already threatened
to do to stave off looming deflation.

Conveniently, the government would repay the debt in dollars
that would be worth a lot less than today's dollars. Again,
there is nothing new in this little game. Every global
powerhouse in history has played the same game. What is
amazing though, is that judging by the dollar's current
value, it seems that very few foreign dollar holders have
fully caught on.

God help America the day when everyone catches on.

Regards,


Frank Giustra,
for The Daily Reckoning