Credit Bubble No More, But Systemic Rick Lingers

Financial markets during the last six months have been as volatile and difficult to read as any in history. The massive credit bubble which we had described in our Shareholder Reports for the last five years finally burst and the response by governments and central banks has been much as we predicted, only more so.

In the last four months of 2008, the dominant theme was systemic risk. There was real fear of a complete collapse of the banking system and two asset classes performed well - gold and U.S. Treasuries - both perceived safe havens in the event of a deflationary spiral of defaults. Although it was subject to intense, forced liquidation in October and November, gold recovered to finish the year higher�- its seventh successive yearly gain.

The first one hundred days of 2009 have brought a significant shift in investment sentiment. Unprecedented world-wide fiscal and monetary stimulus has largely allayed the fear of systemic collapse. At the same time, concern about the inflationary impact of the stimulus has been muted. Opinion leaders have told us that the immense destruction of wealth and credit, and the resulting major contraction in the world economy, will deflate prices. We have also been assured by the monetary authorities that excess money will be withdrawn from the economy when it is no longer needed, and before price inflation becomes a problem. Why anyone should believe this promise when excess money creation by the same authorities in 2002-2004 created the credit bubble that is now our undoing is a puzzle. But the market does appear to believe that inflation, if possible, is a long way off.

Gold is now caught in a perceptual bind. The general consensus is that the environment is deflationary but without significant systemic risk of default. Gold's best attributes�- it is no one else's liability and its supply is relatively inelastic compared to fiat currencies�- have both been downgraded in value. With no compelling reason to buy it, gold now appears to be in a trading range of US$850-950 as we write this, while equities, particularly bank stocks, are flying.

We believe that the perceptual bind limiting gold's advance has its roots in a misunderstanding of inflation/deflation and a misreading of recent economic developments. Once the reality of our situation becomes clear, gold will, in our view, resume its upward march against all major currencies.

Let's summarize the case for deflation. Asset prices (stocks, corporate bonds, real estate, etc.) have collapsed, wiping out perhaps US$50 trillion in private wealth world-wide. The financial system is rapidly de-leveraging. The shadow banking system, which funded and managed the securitization markets that provided most of the credit over the past few years, has almost disappeared. Commercial banks cannot generate enough credit to take up the slack because many of them are effectively insolvent�- they have negative or negligible net worth. International trade has fallen off a cliff, industrial production is down sharply, unemployment is rising and retail spending is weak.

There are only two holes in the deflationary argument but they are big ones. Money supply is not contracting. Nor is the general price level falling on a year-over-year basis �although a huge reduction in inventories has temporarily reduced the prices of many items.

First, consider money supply. In a genuine deflation, prices fall in response to a falling money supply which raises the value of money in comparison to goods and services. The Mises Institute calculates a measure they call True Money Supply (TMS), probably the best available indicator of monetary inflation because it eliminates double counting and does not include bank reserves. Deflationists correctly argue that excess bank reserves created by central banks do not increase the money supply if banks do not lend them out into the economy. TMS considers only money immediately available for expenditure including currency in circulation, chequing and savings accounts and government demand deposits.

In the U.S., TMS is now rising at a greater than 10% annual rate and its growth appears to be accelerating. TMS has not at any point in the past six months gone negative. The U.S. Federal Reserve and Treasury continue to borrow into existence far more money than has been extinguished via debt repayment (de-leveraging). Public policy is working effectively to produce monetary inflation because it no longer relies on conventional reductions in interest rates and the expansion of bank reserves; the Federal Reserve and Treasury are bypassing the banking system, aggressively monetizing public and private debt, buying these assets using newly printed money.

Remember that debt default does not reduce money supply�- the money originally loaned remains in the economy�- nor does a decline in wealth due to falling asset prices. These developments may depress the propensity of private lenders and borrowers to do business but fiscal and monetary stimulus (a public sector debt bubble) is more than offsetting the collapsing private sector debt bubble. We believe that when commercial banks begin to lend out their enormous quantity of excess reserves provided to them by the central banks (and we believe they will do so to take advantage of the huge spreads between central bank lending rates and returns on low risk private assets), the rate of monetary inflation will soar.

Commodity prices began to stabilize last December and have been rising in 2009, providing early evidence, we believe, of the impact of monetary inflation on the real economy. Officially reported U.S. CPI-U for March 2009 showed a very slight decline on a year over year basis for the first time since 1955, primarily due to lower gasoline prices which have since rebounded. There is no evidence in current official CPI reporting of the price deflation that occurred in the early years of the Great Depression. Furthermore, it is well documented that politically-driven changes in the method of calculating official CPI over the past 30 years have resulted in a significant downward bias in the official rate of inflation. Shadowstats.com publishes an independent CPI calculation which reverses the changes made to the computation methodology since 1980. Their March CPI rose 7.25% year over year using the same data as the official CPI-U.

Will Central Banks Take Back the Monetary Stimulus?

As monetary inflation begins to express itself, will central banks quickly remove excess money from the economy as they promised? We think not. History tells us that by the time the general price level begins to rise, it will be too late to avoid an inflationary problem because of the substantial lag effects of monetary policy. Moreover, as public money moves into markets for commercial paper, mortgage securities, student and consumer loans and treasury securities, these markets become dependent on this rate-insensitive funding and interest rates no longer reflect what private creditors would be willing to accept. Furthermore, in the case of the U.S., history contains a lesson well known to the Federal Reserve. After the confiscation of private gold and the devaluing of the dollar against gold in 1933, price deflation was reversed; monetary and price inflation began. To curtail rising prices, the Federal Reserve tightened bank reserves, effectively withdrawing money from circulation. The economic recovery collapsed and the Great Depression resumed.

How inflationary are current policies? Grant's Interest Rate Observer suggests calculating the fiscal and monetary stimulus as a percentage of GDP and adding them together. Grant's measure of fiscal stimulus is the cumulative change in the federal budget deficit from the economic peak to the trough, while monetary stimulus is measured as the expansion of the Federal Reserve balance sheet during the same period. From August 1929 to March 1933, the peak and trough of the Great Depression, monetary stimulus amounted to 3.4% of GDP and fiscal stimulus a further 4.9% for a total of 8.3% of GDP over 45 months. That's our historic benchmark. From December 2007 to March 31, 2009, estimated monetary stimulus is 18% of GDP and estimated fiscal stimulus is another 11.9% for a total of 29.9% of GDP over just 15 months. If we have not yet hit the trough in the current downturn, we can certainly expect more stimulus, judging by the public statements made by U.S. policy leaders. But commitments already amount to more than US$4 trillion, about four times the level reached in the first 45 months of the Great Depression, as a percentage of GDP.

The above tally of direct stimulus does not include a further US$8.9 trillion in guarantees and backstops for everything from the commercial paper market to money market funds, financial institution debt, the balance sheets of Citigroup and Bank of America, the new Public-Private Investment Program designed to finance the purchase of toxic assets from banks, and expanded bank deposit insurance coverage.

The size and scope of the expenditures and pledges of the U.S. authorities alone are beyond anything imaginable just one year ago. The last major industrialized power with significant foreign-owned debt that ran a fiscal deficit of more than 10% and embraced a quantitative easing strategy involving purchase of its own federal debt was the Wiemar Republic. The United States is not pre-war Germany but it is on a dangerous path. Its fiscal and monetary authorities are determined to support asset prices and create inflation. Who are we to argue with their chances of success? In voting for gold, we vote with the Federal Reserve.

Every successive attempt in the U.S. to battle economic downturns since the Second World War has shown a diminishing return for deficit spending and monetary expansion. This downturn will prove no exception. More stimulus will be required because debt levels have increased and the impact on economic growth of an additional dollar of debt has declined steadily. For those who think that the worst is over, consider that consumer and corporate debt delinquency rates continue to rise much faster than bank charge-offs (meaning there are more write-downs to come), and a flood of commercial real estate defaults lies just ahead. The impact of rising unemployment is not yet fully reflected in the economic data and when it is, the cry will be for more stimulus, more efforts to "reflate".

But the most important issue for investors is what we call the "funding crisis". How will all the stimulus be financed? For the U.S., we expect to see the 2009 budget deficit approach US$3 trillion given the spending commitments that have been made and rapidly declining tax revenues. We do not believe this amount can be funded out of the debt market without substantially higher interest rates which would be devastating to an economy which is already on its knees. We therefore expect the Federal Reserve to monetize a high percentage of this deficit funding and that other central banks will follow suit, driving up the supply of fiat currencies and depressing their value.

Looking Ahead?

Where will the monetary inflation go? Probably not to the asset classes governments want to support�- real estate and stocks, for example�- where losses have been enormous and investor confidence has been lost. Not all prices will rise evenly throughout the economy. Money will flow disproportionately to assets that investors perceive can protect them from declining values in currencies and financial assets. We believe the policy decisions have already been made that ensure gold will become the preferred asset for investors world-wide. We expect this development to begin to occur over the next year as fears of deflation are replaced by expectations of inflation. In our view, the gold price will ultimately rise to levels that are just as unimaginable now as today's monetary policy was unthinkable a year ago. We believe our strategy of maximizing gold ownership per common share without the added risks of third world property locations or Seabridge-managed mine construction and operations could yield an extraordinary return for our shareholders.

Report to Shareholders (excerpt)April 14, 2009

‍