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Special Report-Gold April 6, 1998

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RE: Special Background Advisory:Gold and National Treasuries

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* What follows on gold and the international treasury system needs further modification, but will do for now. Gold is obsolete in terms of being a reliable store of value and is in the process of being de-monetarized, but it is a long-term project that has only recently become coordinated among the Central Banks of Europe. Theyâve gotten smart and the price of gold has returned above $310/ounce as of today, but goldâs long term prospects remain tarnished.

* In particular, at the beginning of last Dec., when the EU was setting up its common central bank, the word was that it would not accept gold as part of national reserves, but would take hard currencies and treasury bills from the US, German, US and other major States treasuries. That has changed. On March 21st Belgium confirmed a major sale to five other central banks as reported in a Reuters wire of that date:

ã "The buyers were only central banks. This has not had any impact on the gold market during this period," Maystadt told reporters at a meeting of European finance chiefs.

ã The NBB announced last week it had sold 299 tonnes of gold to five unnamed central banks, leading analysts to speculate whether the gold had subsequently leaked on to the market, depressing prices. (Per another story Belgium received 109 Bil Belg Francs @$1=37.83, or $2.88 Bil @$9.636 Mil per tonne. --BCW)

* The spill-out is that the EU bank will accept 1/3 of member reserves in gold and that the treasurers will then, slowly liquidate down their gold holdings over the next 25 years or so --the numbers for gold holdings indicate a liquidation process may take 50 years to effect. The treasurers are slipping one over on the people in that they are content to let investors think gold has a financial value while they gradually sell their holdings into the market. The obverse is, that from time to time, a useful idiot will call for firming up "the gold standard" as a political issue and will be shilling either for the mining companies or the treasuries.

* Not every treasury holding gold is coordinated in this project and we expect to see a few more significant sales, as well as forward selling by gold mines. So a price above $325 seems unsustainable and most new mines are designed to come in at a production price per ounce as low as $100-150 per ounce. Recovery for South Africaâs mining industry is not in the cards.

* On March 25th, The Wall Street Journal reported: ãKingdom of Lesotho Tunnels Into Trouble As Gold Prices Dive.ä It noted that 50,000 miners had been laid off in 1997 and another 50,000 were expected to lose their jobs in 1998. Each miner, though only earning an average of $12 per day, was supporting another 12 dependents in Lesotho through the economic activity of remittances.

* Herewith an exploratory letter to the Editors of The Wall Street Journal written in December and revised in early January:

Letter of Jan 7, 1998 (originally written Dec. 3, 1997)

* Note: Jude Wanniskiâs numbers in todayâs (Jan.7) Wall Street Journal Op-Ed are wrong! The world supply of treasury gold is 1.1 bil ounces, not 11 bil; his historic reading of gold and inflation is all quite correct, but that was then... This is obsolete, continental thinking forged by centuries of invading looters; this is not finance.

RE: The End of the Golden Age --Cobwebs in the Transvaal and Fort Knox

* It appears that it took a decline of the price of gold to $300 an ounce, then lower, before most people have awakened to the fact that gold is being abandoned as the standard measure of value and medium of exchange in international exchange. Yet warning signals have been around us for several years now, culminating in the outright liquidation by Australia of over half its gold reserve, 167 metric tons, for US$1.784 Bil on July 3rd. Canberra invested the proceeds in US, German and Japanese Treasury securities. Switzerland, Belgium and the Netherlands have also begun selling or signaled their intentions to liquidate substantial percentages of their reserves. Gold has fascinated man since late Stone Age times (the ãChalcolithicä era when gold, furs, pretty stones and copper became fashionable adornments for the beautiful and mighty) and still looks beautiful, but it has lost its talismanic and fiduciary charms --you cannot eat it and it does not pay interest.

* What is disturbing is that there seems to be an uncoordinated dash for the fire escape building up --central bankers have shown no signs of negotiating an orderly reduction or liquidation of these reserves. Further, there is going to be a pronounced negative impact on current stability and future development of South Africa, formerly the principal gold producer.

* The deflationary argument does not explain goldâs price decline; there is a huge surplus of gold increasingly available from national treasuries which now have an alternative in treasury securities that pay interest and can be hedged, making gold bars obsolete as a convenient store of value. The worldâs central banks and international settlements operations hold some 1.1 billion ounces of gold (still valued at $42.50 per ounce and thus, representing a large capital gain windfall for treasuries when sold at $275-300/oz). For several years there have been significant loans by treasuries to gold mining companies seeking to capitalize on forward sales. In 1997 there have been several open sales by treasuries exceeding 11 million ounces, but no reports of any concerted attempt to liquidate these holdings in an orderly way. At the same time, the signals from the European Union are that its about-to-be formed central bank will not hold any large amount of gold in its statutory reserves. Switzerland wants to revalue some gold at the market to use the funds for refugees. Gold is clearly on its way out of the global treasury system.

* Annual production of gold ranges between 75 and 80 million troy ounces and, as the price trend over the past few years shows demand has about equaled supply, so a liquidation of the world financial supply of 1.1 billion ounces would represent the equivalent of 15 years worth of mining. The current rule of thumb is that gold has an average production cost of $275 per ounce and it is clear that thatâs where the price trend is headed; in a market flurry, it is likely gold will even bounce down to the $250 neighborhood.

* Unfortunately, for Nelson Mandelaâs South Africa, the cost of production in the Transvaal mines ranges from $310 per ounce and upwards; at $325/oz, more than half the countryâs capacity was deep in the red and shutting down --output has declined from 1000 metric tons per year in the 1980s to 450 tons in 1996. With gold now trading under $300/oz and headed lower --its decline somewhat slowed by panicked Asian investors-- virtually all the remaining mines will soon close, throwing all those tribal workers out of their jobs; jobs which helped ãsocializeä those workers to the modern industrial economy and society. Once, closed, those deep shaft mines are going to start filling up with ground water: they will never reopen.

* It is not entirely coincidental that the white Afrikaners chose to time the handover to Mandelaâs ANC government a few years in advance of goldâs collapse; the insiders concerned could see the end of the Golden Age coming and at least, the new government got a few years of gold output to help buffer some of the shocks of transition. But going forward in 1998 and beyond, the South African government is going to have increasing difficulties managing the transition from the gold-based economy to a stable industrial society and in terms of productivity, its labor force is not yet competitive on a global basis. The United States will find itself drawn in to support South Africa even while our major trading partners shirk any responsibility and continue to liquidate their treasury holdings to realize the huge capital gains on gold sales at market prices.

* For the United States the financial gold situation is somewhat simpler though, with 261 million ounces ($11 Bil on the Treasuryâs books and about $78 Bil at a $300/oz market price), it holds the largest reserve and will have to be the last treasury out of the market. What has replaced gold as the reserve store of value in the international banking system is our $4 Trillion public Treasury Debt. Bills, notes and bonds of the US, Germany and Japan are what now provide liquidity and the run-up of US debt in the 1980s and early 90s is, in large part, responsible for the ability of the Global economy to expand --but thatâs another story (see below). Current Asian events may suggest the expansion has gotten a bit ahead of itself but thatâs a side-effect of corrupt politics and financial practices and could not be prevented by a reversion to a gold standard. All this makes one wonder, though, why did Al Gore et al work so hard to get Congress to pay off a Canadian mine developer to not open that gold mine just outside Yellowstone? Who conned whom on that one?

* So whatâs a survivalist cum gold-bug to do? Shotgun shells have more value than gold coins in an apocalyptic world, but who really thinks the worldâs going to sink into a new Dark Age? Only environmental Luddites.

The Coming Shortage of US Debt

* With the collapse of the credibility of gold as an international store of value in global banking, Treasury securities of the United States, Germany and Japan have taken on the role of providing liquidity in the system. It is a little understood fact that the explosion of the Federal deficit in the 1980s and early 90s provided a necessary pool of such securities, though for some time it looked like Washington was being irresponsible in wracking up such a large debt and debt service expense at the time.

* Now, with some semblance of fiscal discipline and responsible spending restraints, the publicly traded US Treasury debt, about $4 Trillion, provides a secure pool of investment-at-interest for international treasuries and banking operations and also provides a large pool of investments needed to fund the retirement of the baby boomers and their successors. Hereâs the neat secret about this pool of securities, not only does the US not need to pay off this debt, it would be foolish to the point of fiscal insanity to even retire as little as ten percent of it over time. Let it sit out there where it can continue to provide a safe, liquid investment vehicle for future retirees. The taxpayer benefits by the reduction of interest rates, now down in the 5.75% range and headed lower; a 1% reduction in the interest rate on treasuries just on this publicly traded portion of the larger debt means a potential $40 Billion a year in savings as older 10 and 30-year bonds at higher coupons begin to retire in favor of 5.75% or lower issues.

* Prudent American investors have a limited range of choices for their funds: Treasuries, municipals, stocks, real estate and foreign market securities. We have seen that foreign markets are too small to absorb the increasing volume of US funds available for investment and, further, most are either relatively moribund, as in Europe, or undisciplined, as with the Asian markets.

* American real estate is also fraught with risk, fraud and corrupt practices as the 1974 Real Estate Investment Trust (REIT) collapse and the 1986-87 Savings & Loan meltdown proved. This leaves the Treasury and stock markets and the flow of funds have pumped up prices in both in the ãBalanced-Budgetä bull market of 1995-97, triggered by GOP control of Congress and the Federal purse strings. Now, with the Fiscal Year 1997 Federal deficit down to $22 Bil, the US Treasury is no longer issuing large volumes of new debt to help expand the necessary investment pool, posing a problem for fund managers and investors who must chase a non-growing supply of attractive investments. We have a supply-demand problem shaping up.

* The longer-term prospect is this; not only is the Treasury supply going to shrink in relative terms, yields will decline to the 5% range or even less --the range we experienced from the late 1940s well into the 60s. At the same time, blue chip companies like IBM vainly buy in shares seeking to improve the capital gains performance of their stocks, further limiting the supply of quality investments, while not really achieving their capital gains appreciation goals. Newer companies with high cash flows, such as Microsoft, have not even begun to build a dividend stream to reward long-term investors with approaching fixed-income needs. Not only is the supply of prudent investment vehicles shrinking, the supply of yield-oriented investment vehicles is shrinking faster, leaving investors open to risky, reckless, even fraudulent REITs, holding highly leveraged properties at inflated prices and now flooding into the market in a replay of the 1970s game.

* Regulators must crack down on the REITs before there is another damaging speculative bust that falls unevenly on fixed-income oriented retirees. Congress should hold to its fiscal discipline and seek to actuarially correct the Social Security and Medicare accounts for the long term. As the social security trust fund begins to liquidate, those securities will be snapped up by an investment market hungry for quality product.

* Interest rates are moving down and the 30-year Treasury may well dip below 5.5% and remain there if Congress continues to practices fiscal responsibility beyond 1999. Investors providing for retirement will, therefore, need to save more money than they currently project, on investments yielding lower returns, to provide for a comfortable retirement. Congress may, at a not-too distant date, find that it needs to provide a special class of Treasuries at an above-market interest rate for individual retirees --a new savings bond program.

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