Gold poised as dollar suffers from US spend-fest


By: Paul van Eeden
Posted: 07/21/2001 04:00:00 AM | © Miningweb 1997-2001
SAN DIEGO - It has become quite boring to talk about the gold price since
many analysts are now focusing on its relationship to the US dollar and there
must be a thousands of people who are more qualified to analyse the dollar
than I am. But since I am not overcharging for this communication, I will give
you my opinion anyway.
The gold price trended up last week while the dollar lost ground in response to
Alan Greenspan's testimony before the House Finance Committee. According
to Mr. Greenspan, the US economy has not yet shown signs of a recovery,
making the chairman sufficiently concerned to suggest that further rate cuts
are not out of the question. Wow!

Let me see: the problem in the US is that so much foreign capital poured into
the country that the cost of capital declined precipitously causing both US
consumers and corporations to go on a spending binge and whenever their
appetite exceeded their income, they turned to debt. The end result is record
bankruptcies and debt levels during one of the most pronounced economic
booms in the history of the United States. Not to mention the egregious
allocation of capital and gross asset inflation that resulted. This is of course
where the current danger lies.

But Greenspan is not worried. Even though he has had to lower his estimates
for US growth yet again, he is predicting a much rosier picture next year.

If all goes well, the interest rate cuts, as well as the tax rebates are going to
kiss US consumers and make them feel all better. This appears to be highly
unlikely. The amount of the tax rebate is nothing in comparison to the size of
the economy and how can short term interest rate cuts solve the problems of
over-extended balance sheets when long term interest rates are actually
increasing. Looked at another way - why would interest rate cuts help the
economy if consumers are already leveraged to the hilt with debt. If they
cannot borrow any more, they cannot borrow any more regardless of what the
interest rate is. Didn't Japan clearly illustrate this point?

According to the Wall Street Journal,"Much of the economic slowdown
comes from businesses rapidly and sharply cutting back on production in the
face of sagging demand...Economists say once companies work off excess
inventories, they will be in a position to rev up production..." Herein lies
another problem.

During the increase of a business cycle when demand is strong, companies
tend to increase inventories which become a burden if demand declines again.
A recession occurs when demand declines again and companies have to work
off excess inventory, thus temporarily cutting back on production. This usually
lasts only a few quarters and seems to be what chairman Greenspan is
predicting. But this was not a normal business cycle. What we had was
"irrational exuberance" on steroids. Not only did consumer demand increase,
it increased so much that companies went on a capital spending spree. The
problem now is that corporations don't just need to work off excess inventory,
they stand to lose billions from the misallocation of capital.

That, by the way, is also the hard lesson that investors are busy learning.
When the cost of capital gets too low, capital is squandered and, once
misallocated, is hardly ever recovered.

So the problem we are facing, which no-one yet wants to talk about, is the
misallocation of capital during the recent"New Era". Usually it takes far more
than a mere recession to correct for the gross misallocation of capital. It
almost always occurs only after a prolonged depression. Due to the size of
the US economy, such an event has the potential to slow worldwide economic
growth as well.

What does any of this have to do with gold? Only that the price of gold is
inversely correlated to the US dollar and if the US faces the prospects of a
depression, do you think that foreign investors are going to continue to pour in
the order of $400 billion a year into the US economy? Especially after what
they did with the capital during the past ten years? I bet that when analysts
start calculating return on equity and return on capital for US corporations, on
capital invested during the past five years, it is not going to be pretty.

When this financial storm finally blows into town, hold on to your hat. Hold on
to your gold stocks too.

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