The Coming Dollar Crisis & Subsequent Gold Boom

January 31, 2008

There are at least four economic and stock market crises that I’ve studied extensively that mirror today’s global economic conditions. Only many things today make today’s situation in many aspects much worse than the conditions that triggered past crises. That is why I say crisis is inevitable and great wealth will be destroyed in global stock markets. However, great wealth can also be built during this time as well. You don’t have to be a passive investor whose wealth will be destroyed. Here, I’ll examine just one of these crises – the 1997 Asian Financial Crisis and how the triggers for this crisis do not bode well for today’s situation.

The 1997 Asian Financial Crisis

Prior to 1997, the Asian “tigers”, in particular, South Korea, Thailand, and Indonesia attracted foreign investment in three manners: (1) The liberalization of investment policies and consequent elimination of restrictions on capital inflows; (2) the maintenance of high domestic interest rates to attract capital inflows; and (2) the pegging of domestic currencies to the U.S. dollar to allay fears of volatile currency movements.

Extremely high 8-12% GDP growth rates in South Korea, Thailand and Indonesia in the mid-1990s created rampant foreign speculation in real estate markets and created unsustainable inflated real estate prices. When the real estate bubble burst, a flight of capital ensued. As foreign currencies were withdrawn at record levels, the domestic currencies of the Asian tigers suffered great depreciation in their exchange rates against the Western denominated currencies of the investing nations. To provide stability to the economies of the Asian tigers, the IMF proposed a 3-pronged solution: (1) Cut back on government spending to reduce deficits; (2) Allow illiquid banks and financial institutions to fail, and (3) Aggressively raise interest rates to strengthen domestic currency.

Historically Comparable Scenario: 2000-2007 U.S Economic Timeline
– Dot com crash, U.S. Federal Reserve manufactured real estate bull, Subprime mortgage fallout. Consequence: Real estate bear and depression??

The dot com bubble collapse caused the U.S. NASDAQ index to plummet from a peak of 5,038 in March, 2000 to 1,114 in October, 2002— a decline of 78% in less than three years. Runaway valuations and frenzied buying of a hot sector caused the tech market to collapse as investors and venture capitalists threw money at tech companies, inflating the value of companies that had never declared a single dollar in revenue or profit. Even though revenues, earnings and cash flow were all absent, this didn’t seem to make a difference as a rapidly rising index provided a rising tide that lifted all boats regardless of the missing components of quality or fundamental soundness.

When the unsustainable tech bubble burst, to ease the pain of losses in the stock market, the U.S. Federal Reserve cut the Fed Funds interest rates a dozen time from 6.5% to 1.25% (the discount rate was cut 13 times to 0.75%) and spurred massive speculation in the housing market. These massive interest rate cuts achieved two simultaneous goals: (1) They pulled the U.S. economy quickly out of a deep recessionary environment; and (2) Fueled massive equity gains in the housing and RE market that allowed many Americans to forget the pain they had just suffered in the stock markets.

However, those interest rate cuts directly created the sub-prime crisis that reared its ugly head in 2007. As buyers jumped into the U.S. real estate market to buy houses beyond their budget, courtesy of the Fed’s cheap dollar policy, rampant speculation in the real estate market created an unsustainable rise in real estate prices. In 2007, this lax fiscal policy came home to roost as a period of increasing interest rates caused defaults on low-quality, high-risk subprime mortgages. In turn, these defaults created a global liquidity crunch.

Interestingly enough, remember what the IMF’s solution for the Asian tigers was back in 1997 (a solution that worked by the way) (1) Cut back on government spending to reduce deficits; (2) Allow struggling illiquid banks and financial institutions to fail, and (3) Aggressively raise interest rates. When faced with the exact same scenario (caused by similar conditions), the U.S. Feds instead chose to (1) Raise the national debt ceiling and increase deficits; (2) Bail out insolvent banks and financial institutions by printing as much money as they needed; and (3) Aggressively reduce interest rates. Does anyone really believe that this solution will end well?

Strong and continued inflation of a currency will always invoke a couple of reactions:

1. Wealth will be stored not in domestic currencies but in non-monetary assets or in a relatively strong foreign currency to maintain Purchasing Power Parity (PPP).

2. Monetary and trade transactions occur in a foreign stable currency, not the domestic currency.

Certainly condition (1) has been executed by Americans, at least among savvy investors, for many years now with the accumulation of foreign currencies as well as the accumulation of lots of gold, silver and real estate in emerging and developing countries. Condition (2), while not yet common, is starting to appear. I’ve seen U.S. based merchants online now demand Euros as the default currency of payment rather than the dollar.

The examination of history above tells us that the only thing that can save the dollar right now is its replacement with a new currency, much like the German papiermark was replaced by the Rentenmark after the Reichsbank’s post-WWII hyperinflation monetary policy caused the utter collapse of the German mark. However, given that political deals struck between the U.S. government and OPEC back in 1973 ensured the dollar its role in international trade as the de facto international currency, replacing the dollar with an alternative American or North American currency, such as the proposed Amero, will be a monumentally difficult task. For now, the only conclusion I can draw from my brief examination of history is that unless a grand scheme is hatched to replace the U.S. dollar with another currency, great fortunes in gold and gold stocks are waiting on the horizon. Thus one should bunker down and get ready for the great gold boom.

[tags]gold, global recession, dollar crisis, Amero[/tags]

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