A is for Asset Preservation

A is for Asset Preservation: Why Americans Need Gold

Excerpted from "The ABCs of Gold Investing: How to Protect and Build Your Wealth with Gold" by Michael J. Kosares, Second Edition

The possession of gold has ruined fewer men than the lack of it.

-Thomas Bailey Aldrich

The incident is one of the most memorable of my career. Never before or since has the value of gold in preserving assets been made so abundantly clear to me. It was the mid-1970s. The United States was finally extricating itself from the conflict in South Vietnam. Thousands of South Vietnamese had fled their embattled homeland rather than face the vengeance of the rapidly advancing Communist forces.

In my Denver office, a couple from South Vietnam who had been part of that exodus sat across from me. They had come to sell their gold. In broken English, the man told me the story of how he and his wife had escaped the fall of Saigon and certain reprisal by North Vietnamese troops. They got out with nothing more than a few personal belongings and the small cache of gold he now spread before me on my desk. His eyes widened as he explained why they were lucky to have survived those last fearful days of the South Vietnamese Republic. They had scrambled onto a fishing boat and had sailed into the South China Sea, where they were rescued by the U.S. Navy. These were Vietnamese "boat people," survivors of that chapter in the tragedy of Indochina. Now they were about to redeem their life savings in gold so that they could start a new business in the United States.

Their gold wrapped in rice paper was a type called Kim Thanh. These are the commonly traded units in Hong Kong and throughout the Far East. Kim Thanh weigh about 1.2 troy ounces, or a tael, as it is called in the Orient. They look like thick gold leaf rectangles 3 to 4 inches long, 1-1/2 to 2 inches wide, and a few millimeters deep. Kim Thanh are embossed with Oriental characters describing weight and purity. As a gesture to the Occident, they are stamped in the center with the words OR PUR, "pure gold."

It wasn't much gold-about 30 ounces-but it might as well have been a ton. The couple considered themselves very fortunate to have escaped with this small hoard of gold. They thanked me profusely for buying it. As we talked about Vietnam and their future in the United States, I couldn't help but become caught up in their enthusiasm for the future. These resilient, hard-working, thrifty people now had a new lease on life. When they left my office that day, there was little doubt in my mind that they would be successful in their new life. It was rewarding to know that gold could do this for them. It was satisfying to know that I had helped them in this small way.

Buy ABCs of Gold InvestingI kept those golden Kim Thanh for many years. They became something of a symbol for me-a reminder of the power and importance of gold. Today, when economic and financial problems have begun to signal deeper, more fundamental concerns for the United States, I still remember that Vietnamese couple and how important gold can be to a family's future. Had the couple escaped with South Vietnamese paper money instead of gold, I could have done nothing for them. There was no exchange rate for the South Vietnamese currency because there was no longer a South Vietnam! Wisely, they had converted their savings to gold long before the helicopters lifted U.S. diplomats off the roof of the American Embassy in 1975.

Over the years, I have come to understand and appreciate the many important uses of gold-artistic, cultural, economic, and industrial. Gold is unsurpassed for jewelry and as a high-tech conductor of electricity. Gold has medical applications in dentistry and in treating diseases from arthritis to cancer. Gold plating is used in computers and in many other information-age technologies. All of these pale, though, in light of gold's ancient function as money. As an asset of last resort, gold makes its most important contribution to the general welfare. Through the many economic debacles in human history runs one common thread: those who survive financially do so because they own gold. In recent years, gold has regained its glitter among American investors. This renewed interest in gold is not so much a hedge against the devastation of war but against something much more subtle-the potential destruction of wealth from an international collapse of the dollar and a subsequent economic breakdown.

The Stressed U.S. Economy

The telltale symptoms of a currency and an economy in stress dominate the U.S. financial and political scene. The litany is familiar: massive federal government deficits, a burdensome and virtually unpayable national debt, a rapidly growing foreign-held debt, unsustainable levels of private indebtedness, confiscatory taxation, high structural inflation rates, and declining productivity across the board. However, only a handful understand that these problems are interrelated and deeply rooted, and that they directly affect the viability and value of investment portfolios for all Americans. These problems have not suddenly appeared on the horizon, demanding attention. They have been with us for a long time, and they have been steadily eating away at the foundation of the American economy: the value of the U.S. dollar. Many are hoping this deteriorating situation will simply disappear, but most of us know that is unlikely. More likely, the situation will worsen.

Just as our bodies adjust to and become inured to the cold, so too our minds have become dulled by the repetitive, steady drumbeat of statistics that prove our economy is in crisis (Figure 1).

Figure 1: Disturbing Economic Trends

In 1970, the budget deficit was a meager $2.8 billion. By December 2003, it had reached $477 billion-170 times the 1970 figure.

In 1970, the accumulated federal debt was $436 billion. By December 2003, it threatened the $7 trillion mark. This figure does not include so-called off-budget items like long-term Social Security and Medicare obligations, which balloon that figure by multiples.

Exports and imports were roughly balanced in 1970. The last time the United States ran a trade surplus was 1975. By 2003 year's end, the trade deficit was estimated to be a dismal $490 billion for the year.

In the process, the United States has gone from being the greatest creditor nation on earth to being the world's greatest debtor nation. In 1970, U.S. debt held by foreigners was a mere $12.4 million. By the end of 2003, it approached a dizzying $1.5 trillion. The problem of foreign-held debt has become so acute that some experts wonder whether the United States will be capable of pursuing its own monetary policy in the future, or whether the dollar is now hostage to our foreign creditors.

Belying political claims that inflation is under control, the actual consumer price index has shot up 490 percent since 1970.

While proclaiming that the American consumer has never had it better, many politicians neglect to mention that since 1980, individual tax collections by the government, not including Social Security, have gone up over 350 percent on an annualized basis over the 1970 figure, while the median income has gone up only 240 percent. In other words, taxes have gone up nearly 1.5 times faster than income. This fact helps explain why American installment debt is now over $2 trillion, why it takes two incomes to provide the lifestyle one income provided in the 1960s, the low savings rate, and the stagnant gross national product. If you were to blend Social Security and Medicare payments into that ratio, the gap between income and tax collections would be substantially wider.

Many have concluded that in the face of these seemingly intractable problems, there will be a day of reckoning. The economy has become like the bus in the movie rigged with a bomb. Stop, the terrorist warns, and the bus will be blown to bits. Proceed, and the bus either runs out of gas, in which case it is blown to bits, or ultimately careens out of control with the same result. The massive deficits and national debt continue because, if they suddenly ended, the American economy could not withstand the shock. Yet, if they continue, eventually the American economy ends up either in a deflationary bankruptcy or in an inflationary currency meltdown. As Federal Reserve Chairman Alan Greenspan once stated in congressional testimony, "These trends cannot extend to infinity."

Despite Mr. Greenspan's recurrent warnings, not a single one of these trends shows even a hint of reversing. To the contrary, they seem to be worsening exponentially like a nuclear chain reaction. Rather than acting on these problems, politicians have changed tactics. They now use disinformation, even propaganda, in an attempt to make it appear as if the problems do not exist. Presidential candidate Ross Perot, during the 1992 presidential campaign, colorfully likened the situation to a crazy aunt locked in the attic-the one the neighbors know about, but no one in the family wants to acknowledge.

Let's take the government deficit as an example. From 1999 through 2001, the federal government actually ran a budget surplus for the first time in decades. Receipts topped outlays by roughly $100 and $200 billion annually. That sounded good to most Americans, and the administration of President Bill Clinton greeted the development as a new era in government finance. However, the Clinton administration failed to emphasize that this feat was accomplished not by reduced spending or through better management (although this is what was implied), but by borrowing hundreds of billions from the Social Security fund. By fiscal year end 1997, the accumulated federal debt-what the government actually borrowed to stay in operation-stood at $5.413 trillion. And that bit of juggling of the fiscal books didn't end with the Clinton years.

At the end of fiscal year 2001, with George W. Bush now at the reins of the federal government, the national debt came in at $5.807 trillion. During those three years, the government in reality had added nearly $400 billion to the debt while claiming a surplus of about equal that figure-a miscalculation demonstrating just how far Washington is willing to go to keep the facts from the American people. Neither the Republicans nor the Democrats questioned these figures until the press began to make an issue of it for the 2004 election year-an indication, if not of complicity, then at least of benign neglect. Once again, that crazy aunt in the attic comes to mind. In the pragmatic world of international finance, however, these trends have been enough to cause considerable concern.

The Developing International Currency Crisis

The U.S. dollar is a currency in crisis. Its purchasing power has been eroding in fits and starts since World War II. The 1945 dollar is now worth less than 10 cents. The 1970 dollar is now worth about 21 cents. The 1980 dollar, during a time when Americans were constantly reminded that inflation was "under control," is now worth about 46 cents. Against two of the dollar's most tenacious competitors, the Swiss franc and the Japanese yen, its performance has been dismal. In 1985, it cost Americans 40 cents to purchase a Swiss franc and 0.4 cents to purchase a Japanese yen. In 2004, it cost 80 cents to buy that same Swiss franc and nearly a full cent to purchase a Japanese yen. In other words, the dollar has lost half its value against two of the world's major currencies over the past twenty years. In short, we are headed the wrong direction on a one-way street. Someday, the oncoming rush could overwhelm us.

Historically, assets denominated in a currency gone bad can be ultimately submerged in a sea of debased paper value, sometimes never to recover-the infamous Nightmare German Inflation of the 1920s being one of the more conspicuous examples. In that notable episode of a currency gone bad, the wholesale inflation index went from one to 726 billion. An individual's life savings could not purchase a loaf of bread or a cup of coffee. People would line up early in the morning to purchase goods they knew would escalate in price by afternoon. Wage earners were paid twice a day and wives would wait at the factory gate for their husbands' paychecks to spend them before prices went up again.

Although the United States has never seen inflation reach that advanced state, the many parallels between 1924 Germany and the present-day United States are cause for concern. Few can look at the constant depreciation of the dollar since the early 1970s and fail to be alarmed that the currency could someday go off the rails. It seems we differ from 1924 Germany only in the duration between cause and effect. Whereas the German experience was compressed over a few short years, ours has been more protracted. This has occurred for two good reasons. First, American central bankers have learned enough from the German experience to delay, extend, and make more tolerable the consequences of excessive money printing. Second, Germany was a small state isolated from the rest of the world, a pariah nation of sorts after the World War I Allied victory. As a result, it had a difficult time finding a market for its government bonds. German deficits had to be financed internally-an impossibility that greatly accelerated the government's printing of fiat currency.

Fiat currency or money is paper money that a government has declared to be legal tender, despite the fact that it has no intrinsic value and is not backed by reserves. Most of the world's paper money is fiat money.

Until recently, the United States enjoyed a strong and unquestioned worldwide demand for its government bonds, so the negative effects of government deficits were subdued. But now, low interest rates and a growing fear among G-7 nations (the United States, Canada, the United Kingdom, Germany, France, Japan, and Italy) that U.S. deficits are out of control has threatened the market for U.S. Treasury securities overseas. Although central banks as a whole have not yet started dumping the dollar, they have slowed their purchases. Should the market outside the United States dry up, the Federal Reserve, like the German central bank in the 1920s, will be forced to monetize an ever-larger portion of the debt to keep the government in operation.

In February 2004, Federal Reserve chairman Alan Greenspan told Congress:

The imbalance in the federal budgetary situation, unless addressed soon, will pose serious longer-term fiscal difficulties. Our demographics- especially the retirement of the baby-boom generation beginning in just a few years-mean that the ratio of workers to retirees will fall substantially. Without corrective action, this development will put substantial pressure on our ability in coming years to provide even minimal government services while maintaining entitlement benefits at their current level, without debilitating increases in tax rates. The longer we wait before addressing these imbalances, the more wrenching the fiscal adjustment ultimately will be . . .

[G]iven the already-substantial accumulation of dollar-denominated debt, foreign investors, both private and official, may become less willing to absorb ever-growing claims on U.S. residents. Taking steps to increase our national saving through fiscal action to lower federal budget deficits would help diminish the risks that a further reduction in the rate of purchase of dollar assets by foreign investors could severely crimp the business investment that is crucial for our long-term growth.

Faced with such prospects, the Federal Reserve might exercise the other option, the one Greenspan referred to less than a year earlier in another statement, "It could very well crank up the printing press and flood the economy with money."

The largest deficit during the Richard Nixon years was $23.4 billion; Gerald Ford, $73.7 billion; Ronald Reagan, $221.2 billion; George H.W. Bush, $290 billion; Bill Clinton, $350 billion; George W. Bush, $500 billion (projected). This, to say the least, is a frightening progression. The question arises: How far might our creditors be willing to go in supporting a system of perpetual debt in which the United States is the debtor and they are the creditor holding billions in unbacked paper currency? The future of America, as Mr. Greenspan points out, seems to hang on that question.

In the end, the correlation between deficits and inflation is sacrosanct: deficits lead to inflation, and uncontrolled deficits lead to uncontrolled inflation. Whether or not there will be a Nightmare American Inflation remains to be seen. Let it be said, though, that the trend is not favorable. Those who survived the German debacle did so by purchasing gold and other tangible assets early in the process-one of the more famous proofs of the value of gold as a means to asset preservation.