Monday, November 5, 2007

From Economic Power to Economic Powder

JEDDAH, 6 December 2004 — The current situation with Iraq has all the ingredients of a long-term liability to the balance sheet of America, which some day it might be a disaster to the state of world economy.
The administration of Iraq under the auspice of the US military and the effort to create a functioning democracy may end up being a long and bloody exercise indeed.
History has shown that the Middle East does not respond well to occupation by the West. From the Crusaders to the British, the eventual outcome is always an exhausted retreat. Trying to impose democracy on a region populated by a multitude of sects and tribes that all hold grudges that go back (in some cases more than a thousand years) may be challenging to say the least.
Furthermore, given that the US will have influence as to which specific Iraqi groups and people will be allowed to participate in this process, it will create turmoil and violence, to say the least. Democracy is a concept that must evolve, with groups of people that wish to live together and with a proper institutional infrastructure in place, which is an unknown phenomena in the Middle East, let alone Iraq.
Secondly, whatever is being promoted as the reason de jour behind the invasion (oops, I mean liberation) of Iraq, i.e. elimination of WMD, preventing state-sponsored terrorism, regime change etc... it is increasingly evident that there is a much larger plan at play.
The debate over current US foreign policy will continue. I will leave it to future historians to judge whether America was acting in self defense and for the benefit of the oppressed in need of freedom, or whether it was acting out of economic self-interest. I will say though, that “freeing the world from evil” might be a long and expensive exercise... For the purpose of this analysis, it only matters how much this current adventurism will cost the US economy and how the rest of the world perceives America’s intentions. The magnitude of the economic costs will negatively impact the US dollar and foreign perception may amplify its fall.
In the long run, imperialism and over-consumption (borrow-spend) are recipe for economic decline.
Truly amazing, when one looks at the current sad state of America’s public and private balance sheet, and its voracious consumption appetite. For although past global powers had their excesses, Americans became the uncontested masters in “borrow & spend” phenomena.
So what has all this to do with the price of gold? The current economic and geopolitical direction of the US will, unless corrected, lead to a long-term decline in America’s standard of living.
The world monetary system has a huge avalanche of US dollars. In addition to foreign owned US bonds and equities, it is notable that more than three quarters of global central bank reserves are in US dollars. The downward trend in the dollar began two years ago and will continue.
Although it has fallen approximately 25 percent against the US dollar index, it is still over-valued and will most likely fall a further 40 percent in the next two years alone. In the long run it may go down a lot further. This bodes well for gold for several reasons. Firstly, as gold is priced in US dollars, the dollar’s decline will make it cheaper to purchase in other currency terms and less attractive for non-US gold producers to produce.
More importantly, if its imperial status is severely challenged and no other currency emerges as a viable alternative (only two are sizeable enough, the euro and the yen, and both have more than their share of problems), then gold will regain its historical status as the currency of last resort and the ultimate store of value and wealth. In this plausible scenario, the price of gold would easily reach well over $1,500 per ounce.
Unfortunately, it seems most Americans are indifferent to the current economic trend, ignoring 2,500 years of monetary history. A history which is littered with lessons about the consequences of virtually every monetary and financial phenomenon we are witnessing today. Excess debt, and other asset bubbles, whether they were speculative manias (the tulip bubble of the 1600’s,) market frauds (the south sea bubble of 1837 and the railroad bubble of 1873), all ended with crashes and subsequent depressions. Inevitably, a combination of these events is almost always followed by subsequent currency debasements.
It is only a question of time. Since October 2002, I have been recommending that investors should diversify out of the US dollar and invest their hard-earned monies in gold (30 percent) and in European deposits.
As for the lesson in this story, unfortunately it will be learned time and time again throughout history and our protagonist, gold, will always be around to provide refuge from man’s inherent need to push things too far.
Finally, for those that read this and dismiss it as mere non-sense, all what I have done is outlining a repetition of history. Although corporate America may be in decline, investment opportunities will always exist. And if not in America, then in other parts of the world, perhaps in emerging economic powerhouses such as China.
(Note: The above article was originally published in the fifth issue (July/August 2003) of Business Horizons, Jeddah, when gold was at $347 per ounce and the euro was at $1.03. As of Friday Dec. 3, 2004, gold price was at $457 per ounce and the euro at $1.3460.)

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