October 12, 2011; Does Gold Rise or Fall in a Deflation?

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Kevin:  David McAlvany, finally back (laughter).  You’ve been gone a long time.  I have been interviewing you by phone now for, I think, three weeks.  You are back from Europe.  You talked to Franck Biancheri last week, and we have gotten a lot of comments on the program.  He does have pretty strong French accent, so if a listener has a hard time understanding any of our interviews, we would direct them to the transcripts, wouldn’t we?

David:  Yes, we do that every week, just as sort of an added service.  Some people like to read versus listen, and that way you can pick it up and come back to it when you want to.

Kevin:  And you can check us for errors.

David:  Well, of course.  Of course, the style is more conversational, and so it reads in a unique way.

Kevin:  Let me ask you a question, Dave.  During last week’s commentary, when we were talking to Frank Biancheri, we were getting a completely different insight than we are getting from the London news, or the U.S. news.  You do have a group of people in Europe right now who are seeing this crisis as an opportunity, like that Chinese character in which crisis can also be interpreted as opportunity.  Is that opportunity for Americans?

David:  No, really, it is not.  It is an opportunity for Europeans, and it is a good opportunity, and I think one of the conclusions that he comes to, and I don’t know that it is going to be as easy a journey.  There is nothing fait accompli in 2015 or 2016, but what is moving that direction is greater integration fiscally, greater integration politically, and as he suggested last week, crisis compresses time.  That said, it is a critical, critical idea that our listeners should wrap their minds around, crisis and time.

Kevin:  These things can really rapidly change.  Something that has been on my mind since I heard the interview was that he talked about a transnational referendum that would overwhelmingly pass, he says, from nation, to nation, to nation, versus what we saw with the Maastricht Treaty, or some of these other treaties, where they had to be passed by Greece, or Germany, or Spain.  I guess the question that I have in my mind is, there is really no ruling government body that could pull that off right now.  Is there a void that is being created that this crisis might bring about?

David:  I guess that is the real question.  How do they move forward fiscally?  How do they move forward politically, when you still have the mechanisms in place to be nationally oriented, not on a broader pan-European cooperative basis running things, whether it is financially, or politically?  I think one of the things that he does point out very well, and we reflect on it this week, as well, is that there is a banking problem, and there is a debt crisis.  But that is not to say that the European Union is dead, or that the euro, as a currency, is dead.

I think this is a critical distinction to make, because oftentimes, we, here in the U.S., will like to say that they are all lumped in together – if one is impaired, the other goes, too.  The surest bet in the world is to bet against the euro, as in the monetary unit, and I would disagree with that strongly – partially, because you have support from China – partially, because you have support from the G20 – partially, because you have a huge invested interest from the most powerful elite in Europe in seeing the euro succeed, in whatever form it ultimately takes.

Kevin:  And partially, because the United States does not have a currency that necessarily offers a really grand alternative.

David:  Kevin, we have talked about paradigm shifts in the past.  Thomas Kuhn wrote The Structure of Scientific Revolutions, which is one of the best discussions of how that happens amongst academics.  One of the things that he makes very clear is that you have to have a substitute model for the old model to be cast out.  What is the new idea?  This is one of the ridiculous things with the Wall Street protests currently taking place.

Kevin:  Everybody is mad, but what about?

David:  And is there an alternative solution?  Are we talking about an environmental concern?  Better green than greed?  We have seen so many different placards, that what exactly this is about is not really clear.  And furthermore, do they offer an alternative solution?  If you have a problem, what is the solution?  Now, to backtrack:  With the currency system, we have defined the problem, not you and I, but there is a growing global consensus…

Kevin:  Well, the markets are defining the problem now.

David:  Exactly, and that problem is dollar monopoly reserve status.  If that is the problem, then you have to have an alternative, so you do catch this strong bid for the euro, specifically, the monetary unit, as the operative alternative, or supplement to, the dollar monopoly system.

Kevin:  Did you catch a little resentment in the voice of Franck Biancheri when he was talking about the established old world order that was established in 1945 with Bretton Woods?  We actually reneged on that when we took ourselves off the gold standard completely in 1971.  I think the rest of the world has a little bit of resentment of the fact that we had guaranteed them a reserve currency, which was a guarantee in gold, and that has been pretty much reneged.

David:  And I think this is something that is pretty critical, Kevin, because from Bretton Woods forward, there was a trade-off with that.  We were the world’s reserve currency, but we also gave the rest of the world access to U.S. markets, and a part of what has made this system work is a system of trade imbalance, where they run surpluses, we run deficits, and it seems to work pretty well.  It is a complete recalibration, post Bretton Woods, to trade off this deficit/surplus exchange, and the recycling of those surplus dollars into Treasuries, something we have done for decades, into a new system altogether.  This is where I think we run a great risk.  We talked about this a little bit in our Friday comments at our Wealth Management website – the Chinese currency bill that is in front of our legislators this week.

Kevin:  Right, blame the Chinese because they are the ones who are doing this to us.

David:  They are manipulating their currency lower.

Kevin:  Right.

David:  Implicit in that is a real problem, because if we take the Chinese currency and raise it, or force them to raise it beyond a normal orderly pace, guess what happens?  One of our primary trade partners all of a sudden sees a diminishing trade surplus, and that diminishing trade surplus, those dollars which were going to be available to buy Treasuries, all of a sudden are no longer available, because they don’t exist anymore.  It is in the category of “Be careful what you wish for,” because, on the one hand, we want to bring about greater global financial stability.  That is the guise that this bill is under.  “If these guys will just stop manipulating their currency…”  That’s how some of our legislators have cast this.  We may, in fact, find that we are sinking the Treasury market in order to create a greater sense of fairness in the world.  How ironic would that be, that we get disaster while trying to bring about stability?

Kevin:  David, the light really went on for me a year-and-a-half or two years ago, when we interviewed Paul Craig Robertson.  He said that the way our economy is built is that we basically deficit spend with foreigners, China being one of the greatest ones of all – let’s say, 400 billion dollars’ worth of a trade deficit.  That means they have 400 billion dollars more of our currency than we have of theirs.  And then they turn around and buy our Treasury bills.  That allows us to borrow money for the next year.  He brought out that things have changed a little bit.  It is no longer a 400 billion dollar trade deficit, so that it is equalizing out, it is now at 1.6 to 1.7 trillion dollars.  There is not enough money, even if we keep these trade partners out there, to continue to fund the debt that we have.

David:  Kevin, we have long said that the Chinese do not buy our Treasuries as an investment, but really, for political reasons, and it is interesting that there were certain foreign governments that, this last week, sold 66.6 billion dollars of U.S. Treasuries.  That is from August 31st until today.  This is what is interesting.  If you look at a chart of the U.S. Treasuries, you see something that has gone up, and up, and up, and up, and up, in price, and there is, for someone – maybe it is a sovereign wealth fund, with a slightly different mandate, there is the investment motive, not simply a political purchase in the Treasury market – 66.6 billion dollars of liquidations by foreign entities since August 31st.  If you look at the chart, it makes all the sense in the world.  You are selling at record prices.  Treasuries have never been this high, and yet, the market consensus is that we need to be moving out of equities and into bonds, because bonds are a safe haven asset.

Kevin:  David, I think you mentioned recently that there is a misunderstanding, or a miscalculation, with this move into the dollar and the move into Treasuries, and that miscalculation is that the people right now are moving toward liquidity, but they are ignoring solvency.  In other words, they are getting into something that they feel is liquid, because it is cash, or Treasuries, or what have you, but there is a solvency issue, just like we have seen in Europe.

David:  This is the danger of logic, because they are buying on a logical basis.  They are buying Treasuries because it makes sense to buy Treasuries.  But consider this.  They may be asking the wrong question altogether, and that is the problem.  If they are buying on the basis of liquidity concerns, when in fact, liquidity is not the issue, but solvency is the issue, they bought Treasuries logically, but with a very faulty premise.  That wasn’t the issue to begin with.

I think what we have seen, and this was a very interesting insight from Franck Biancheri last week, is that the Western media, the Anglo-Saxon media, has something to gain, and considerable gains to maintain, by casting the euro problem as something that is just disastrous.  “You don’t want to buy European bonds, you want to buy U.S. Treasuries instead,” where there is now a gross competition for limited resources, and we really want to see those cash flows coming to us.

Kevin:  David, I would like to shift gears here.  We have asked our listeners to send in questions and they have definitely done so, and we would ask again if they would continue to send questions, because we treat the fall as a period of time where we open up the discussion to our clients, and to our listeners, and we ask if there is something they would like David’s insight on, or other guests, even.  David, what is the email that a person should use to send those questions?

David:  Yes, send those to mcalvany@mcalvany.com.

Kevin:  I am going to go to one of the questions that a client has sent in because I think it brings up a great discussion.  This was a letter that came in a couple of weeks ago.  It says, “Here is a question for the Q&A podcast.  All the experts say that spending cannot be allowed to fall.  If it does, then a vicious cycle starts.  Businesses don’t have much business, so they lay off workers, and that means there are more unemployed, which means less pending, which leads to less income for business, etc., etc., etc., and supposedly, we will continue to spiral downward until we get back, really, to the stone age,” this guy says.  “What would be the Austrian rebuttal to this scenario?  Obviously, we haven’t always had governments to prop up spending.  In history, there have been downward spirals, but they have been temporary.  Something eventually halts them, then reverses the downward spiral.  What is that something?”

That’s a great question, because we are told by the Keynesians that they have to come in and print money, but when they didn’t do that, what stopped the spiral, Dave?

David:  Just to give a preview, I think price is the ultimate “something” that stops the downward spiral.  The Austrian response would point to the importance of savings and investment, in order to have sustainable economic growth and wealth creation.  This is something that we can ask anyone we work with or live with, and this is very practical.  “Does an individual grow wealthier by spending every dollar they earn?”  That is essentially what the non-Austrians, or the Keynesians, would suggest.  “We will create wealth by spending every dollar we have.  In fact, we can even create more wealth if we spend money we don’t have.”

That, to us, is a little bit backward.  We think that wealth is a product of thrift, and thoughtful investment, whether that is in ideas, or enterprises, that multiply access to higher quality, or even greater quantities, of goods.  Again, if you start with thrift, and then look at thoughtful investment, that is different than, “You make it, you spend it.”  What do you do next?

Kevin:  The Keynesians have given us this incredible fear of this word called deflation. You can define deflation a number of ways, but let’s just figure that deflation means that your money, whatever the money is, buys more things, versus inflation, which means that your money buys less things.

David:  Right.  Or the other side of that, which is, those things are more expensive.

Kevin:  So tell me, why is it that I should fear my money buying more things?

David:  Actually, Kevin, if you look at Great Britain, if you look at America, we have had periods of deflation which have been hugely productive, and actually, in terms of economic growth, the best periods in time, because we had relatively constant incomes with declining prices, which means that for the guy who is on a fixed income, or for a gal who is making X amount per year, they get to buy more and more each year, versus less and less each year.

Kevin:  Dave, could you imagine actually going to the store every year, and things costing just a little bit less?  We have never had this in our lifetime.

David:  But if you are seeing innovation, if you are seeing productivity gains, you should, to some degree, see that happen.  Let’s look at the iPhone, which used to cost $500-600 dollars, and now you can buy, the old model, of course, but because there are new models that have come out, you can buy it for about half that much.

Kevin:  Right.

David:  I like the iPhone.  I don’t have one.  I hate my Blackberry.  I have a hate-hate relationship with my Blackberry.  So there is a transition ahead for me to becoming a fully Apple-centered person.  But this is the issue.  It is getting cheaper and cheaper by the day.  We have seen technology progress and productivity has enabled the distribution of a fantastic product at cheaper prices.

Kevin:  Things should cost less.

David:  Again, Kevin, that is just an issue of a price declining to the point where I am compelled to buy.  Going back to that question:  What is the something that stops this spiral?  Kevin, if you came to me and said, “I’d like to sell you my house for a million dollars.”  I’d say, “I already have a house, and I’m really not in the market.”  But if you came to me instead, and said, “Dave, I need to sell my house.  I’d like to sell it for $50,000.  I just need something.  I need some cash now.”

Kevin:  And the house should be worth, $800,000, $900,000, a million bucks, whatever it is…

David:  I’m going to at least stop and think to myself, “While I don’t need it, the price is compelling,” and I may give you some of my money for your house.  Again, I’m not suggesting anything, you are not in financial straights, but the point is, it becomes compelling when the price is the right price.  Now, what is the right price?  That, really, is determined by the business cycle.  Things get expensive, and things get cheap, and if you are buying low and selling high, that is how you make money.  If you are buying high and selling low, that is how you lose money.

And there is a need for the business cycle, where there is something, almost, of a regenerative nature.  Amongst the business community, you have good ideas and bad ideas.  Without the business cycle, bad ideas get to live on, and good ideas sometimes cannot compete, because by the time those bad ideas, should they, in fact, be subsidized through government spending, or Fed liquidity creation, or things like that, then guess what?  The good businesses end up being constrained, and can, in fact, fail, where the bad businesses succeed.  And how does that really help business?  How does that really help the economy?  How does that really help employment?  In fact, it doesn’t.

Kevin:  Okay, Dave, I’d like to play just a little bit of a thought experiment with you.  Let’s pretend we didn’t go off the gold standard, and the dollar actually just maintained value.  And as we became more efficient, and as transportation and production became more efficient, prices actually came down.  That is that dreaded deflation that I think the Federal Reserve wants you to fear.  If that were the case, and you were a savvy businessman, you would go through expansion.  If you were careful, you wouldn’t go into too much debt, you wouldn’t over-expand.  You would save some, for when things began to fall.  You were talking about this guy, maybe me, who needed to sell a house for $50,000.  Well there is a reason I needed to sell the house for $50,000.  I need that.  I am not being forced to do it, I need the $50,000, and you can go ahead and pick up the house at a good buy.  Now, what happens is, that stops the spiral of the business cycle, because then…

David:  Savings come out of the woodwork and get deployed into something more productive than just sitting on the sidelines.

Kevin:  And, I am not Darwinian, by any means, but it is an evolutionary type of thing, where the good ideas actually accumulate more and more assets and produce better ideas down the road.

David:  Right.  The two steps forward.  What we are really talking about, Kevin, is the dreaded one step back, and if you can avoid progress the normal way, what we would see is two steps forward, one step back.  Over a longer period of time, there is progress made.  That is not to say it is without pain.  This is something that I think we all recognize just in the way we live our lives.  Relationships progress and mature, and they are not always easy.  Sometimes it is champagne, and sometimes it is just getting by on bread and water.  In terms of an emotional experience in relationship with someone, there is sometimes a reason to celebrate, and sometimes it is just really not fun.

I think you have those same sorts of ebb and flow in all of life, and the market is not any different, but to go from champagne experience, to champagne experience, to champagne experience, and to believe that that is real, that that is what life is about – that is, in fact, what the Fed holds to in terms of their original mandates.

Kevin:  It produces malnutrition and hangovers (laughter).

David:  You are more right about that than you know.  You are spot-on.  That is exactly what we are talking about — hangovers, which are far more severe than you would ever expect, and malnutrition, because in fact, assets are misallocated and you don’t have healthy growth.  You have a very unhealthy, and a very skewed, economy.

Kevin:  Just a reminder, we have had a slew of questions sent in, but if there is something that we have not covered, or you would like us to cover, send that to mcalvany@mcalvany.com and we will try to cover that question, and if you can get those questions to us in the next week or two, that would help us.

We have been talking in reference to a broad economy, and sometimes even I experience a victim mentality, where I am thinking, “Well, these darn Keynesians, they have been winning since the 1930s.  They have been ruining my money, they have been taking this away, and I have no defense against this.”  But David, we were talking last night, and thinking about this.  Let’s talk about deflation as if maybe it has been actually happening over the last 10 years or so.  We see people who are writing newsletters and talking on TV and saying, “Beware of gold, because if we have a deflation, you are really going to lose money.”

There is a misunderstanding there.  They are treating gold like it is a commodity, like it is one of these other things, when in reality, for the last 4,000 years, gold really has been the underlying form of money.  Just looking at this, when a person calls and says, “Hey, do you think we will have deflation?”  My thought is, in reality, with money being what we just said it was – gold – we have had deflation for the last ten years.  Just look take the price of a house.

David:  Yes, take the price of a house.  Take the value of the stock market.  You have seen that your purchasing power, in money terms, what we are calling gold money terms, has gone up many-fold.

Kevin:  Let’s just take a house ten years ago.  Let’s say it was a nice house ten years ago, worth $300,000.  At $300 gold, that is 1000 ounces of gold.  That same house today, even if it has risen in dollar value a little bit, can be purchased for between 200-300 ounces.

David:  Kevin, what you are talking about is your money, your savings, held in gold, now purchases five times what it used to.  That is an indication of deflation.  Other assets relative to what we would call cash, gold bullion – your cash now buys five times what it did.  In equities, it is even more dramatic.  The over-valuation coming into 2000-2001, now puts you at a purchasing power of between 12-15 times, today, what it was in 2000-2001.

So the dreaded deflation has been happening, and it has been to the advantage, not of the cash-holder, not of the greenback-holder, but to the gold-holder.  I think what people often forget is that gold, as money, does very well in a deflation.  We are not just talking about the last ten years, but if you want to go back into British history, this is the case.  More often than not, gold does better during a deflation than it does during an inflation.  The only exception to that is radical inflation, wherein the repricing is instant, like a hyper-inflation, and then gold is something of a protective measure.  But in terms of a slow bleed – 2, 3, 4, or 5 percent – gold is actually much better in a deflation than in an inflation.

Kevin:  That is what we have been seeing.  It reminds me of a Gary Larson cartoon (laughter) because I’m thinking, “We don’t have to be victims here.  Just let the Keynesians do what they want.  Let them print money.”  But I’m going to go ahead and take that printed money, and I’m going to buy gold, at least for now, and I’m going to put it in the base of the triangle, and I’m going to let myself enjoy the true business cycle.  The Gary Larson cartoon I’m thinking of, and I’m sure a lot of people have seen it – Gary Larson is the guy who does the Far Side cartoons – is a picture of thousands and thousands of sheep, just standing out in a pasture, and one of them is standing up with his arms wide open, and he says, “Wait a second!  We don’t all have to be sheep anymore!”  (laughter)

David:  When you look at what has happened in terms of deflation, the two areas where you have seen the greatest contraction relative to money, and our benchmark for money is gold, are equities and real estate, where you saw the greatest benefit in terms of credit expansion over the last 30 years.   Corporate America was supercharged on a dope served up by the Federal Reserve, as was the real estate market.  Now, where have you seen the greatest hangover?  Equities and real estate.  So where will we continue to see the greatest “de-leveraging?”  Equities and real estate.

Kevin:  With that said, you have continually talked about an exit strategy, and we are not really talking about, necessarily, exiting gold.  We always recommend keeping a third of one’s assets in the metals.  But if we are to employ the business cycle, just like this listener had asked about, there will be a bottoming of this, and you have talked about the ratio to equities when it may be wise to start taking some of your gold profit and go into equities.  Would you recount that again?

David:  Kevin, this is the benefit of a stressful period in time.  It really tests the strength of a business model.  There are some businesses that make it through stressful periods of time, and do very well on the other side, and there are other businesses that are not organized well, that have bad leadership, bad business plans, bad products.   And guess what happens to them?  They go the way of the dodo bird.

Kevin:  Unless the government funds them.

David:  Exactly.  And then you have companies like Solyndra, and all kinds of other businesses which do quite well on the back of taxpayers, not on the basis of a clear business plan.  That is the case where stress in the marketplace is actually very good for helping an investor refine where they should invest their capital productively.  It is only in the context of stress, only in the context of the bottoming of a business cycle where an investor can say, “Now we understand the landscape.  Now we can see who, under stress, has survived and does very well.  I would like to re-allocate my savings (in whatever form that is, and for us that is gold) into something productive, and I see that the field has now been cleared.”  We know who the clear leaders are.  We know where we should be investing capital.

Kevin:  And you are still thinking ahead.

David:  Of course, of course.

Kevin:  You are talking about maybe 2, 3, 4 years down the road.

David:  Exactly.  But we are seeing that process unfold, Kevin, where yes, today your purchasing power is 12-15 times what it was ten years ago – the gold-owner versus the equities owner.  But that cycle will take us to 20, 30, even 40 times purchasing power when all is said and done.

Kevin:  Isn’t that amazing?  And that is a cycle.  That Dow:gold ratio is a cycle you can go back and look at, all the way back to 1896, when they started measuring the Dow.

David:  And that, again, is the agnostic view of investing, where it doesn’t matter whether you are in gold, or in equities, what matters is that you do have a sound understanding of what money is, because your money needs to be there when you need it to be there, and that is the point.  To re-allocate from one to the other assumes that you have maintained your value while the rest of the world has been compressed, and it is normal for this compression to occur.  Again, two steps forward, one step back.

Kevin:  I think about Al Siebert’s book, The Survivor Personality. He is a military psychologist, and he interviewed people who had survived incredible hardships, whether they were military, or holocaust, or some sort of concentration camp-oriented.  What he said was interesting.  He said, “You don’t want to be, or think, in nouns.”  In other words, you don’t want to think, “Well, I’m a doctor, and that’s all I do.”  It is the same thing with investments.  “Well, I own gold.  I’m a gold buyer.”  He says you want to be, or think, in verbs.  You have to be able to flexible, even to the point of healthy schizophrenia.”

I think about the triangle.  For years, we have not recommended 100% in gold.  We have not recommended 100% in equities or cash.  We have recommended a third, a third, and a third, and sometimes that third, like the gold third at this point, just like stocks in the 1990s, has grown to much more than a third of many of our clients’ portfolios.  But there is a time to re-allocate.  Here is this healthy schizophrenia.  You don’t fall in love with any of the sides and just go exclusive with that, do you?

David:  No, you don’t, and that is what allows you to view wealth on an intergenerational basis, to look at investing as a legacy project, wherein, you can give the skills to any generation, to look and say, “Listen, things change.  We know that.  Things change and you have to adapt to change.  There are new ideas that will emerge.  There are new companies that will emerge, that should be considered.  There are new leaders that will emerge that will either hurt or help you, and we are not here to derive an investment thesis on the basis of our political views, or any other views.  Just understand that things change, and that sometimes you will have wind in your sails, and at other times, you will be just focused on survival.”

We are talking about survival of an economic or financial nature.  These are, again, those periods of compression that you would like to avoid if you can.  Or expansion, which you would like to take advantage of, if you can.  The question is:  What causes those periods of expansion to occur?  We have had credit growth for 30-40 years.  Now we have credit contraction.  We have had it for 10 years.  We will probably have it for another 10.  Maybe it will be shorter than that, only a 5-7 year contraction from this point forward, but there is a tremendous amount of debt overhang.

The U.S. economy is leveraged roughly 20-to-1, 53 trillion dollars in debt, 3 trillion dollars in equivalent assets.  That, if you look at our money system, not the whole economy, but just our money system, is a high degree of leverage.  There are going to be winners and losers in this game.  The losers are going to be the ones that are over-exposed, and hold assets that are still in the midst of compression.  The winners are going to be the ones that have cash.

Again, let me define cash.  If you still have confidence in greenbacks, if you still have confidence in the Treasury market, you are making the judgment that liquidity is, now and in the future, the primary issue to be concerned with, and I would caution you to stop, and re-evaluate completely, because liquidity is a concern that comes and goes in a matter of days or weeks.  Solvency is something that stays with you for weeks, months, years, or decades.

That is the issue we have in front of us as a country.  That is the issue that we face, and the concern that many of the deflationists have.  We still have an unwind of a massive amount of debt.  That will occur.  It has to occur.  This is what happens in this kind of business environment.  But, does that mean you go to the worst bet in terms of solvency on the basis of trying to solve a liquidity problem.  Does this make sense, Kevin?

Kevin:  Well, I’m just thinking, the rumors of the fat lady singing on this recession and this de-leveraging, are far overstated.  The fat lady has not sung.

David:  No, in fact, what we see in Europe, we see playing out here in the United States.  It is just a matter of months before it begins to cascade here on this side of the pond.  It is not out of the realm of possibility that we will see the stock market crater over the next few months, and there are characteristics in the fall of 2008 which are being mimicked now.  Very uncertain.  The earnings environment is fading quickly.  There are a number of things which are unsupportive, in terms of the business environment.  Now, what about the larger financial picture?  The larger financial picture is as ugly as it has ever been.  Kevin, this is a case in point.  We have talked about Dexia.  Dexia has now been nationalized.

Kevin:  You were at Dexia.  In fact, we had an account with Dexia, didn’t we, a few years ago?

David:  Sure.  Know when to hold ‘em, know when to fold ‘em.  Know when to walk away, know when to run!  (laughter).

Kevin:  Explain to the listener who Dexia is.

David:  Dexia is one of the larger Belgian banks, and Belgian French concerns, doing business in both countries.  Now it is largely owned by both countries, as in, the governments have had to take over the bank.  Kevin, what we pointed out in last week’s comments was that Dexia was truly on life support, but when the stress tests were applied this last summer, they came out smelling like a rose.  There was no problem apparent at all, according to the stress tests.  The same thing is happening right now with an Austrian bank, one of the largest, the Erste Group, which is now reporting billions in exposure, credit default swap exposure, and major losses, as much as 460 million immediate losses, but they are looking at several billion dollars in losses, given their credit default swap exposure.  What is interesting is that they, too, went through the European stress test, and in the context of the stress test, nothing of their CDS exposure was revealed.  Nothing at all.

Kevin:  This is really scary.  History does rhyme.  It may not repeat itself, exactly, but you are talking about an Austrian bank that was a little bit over-rated, until it wasn’t.  And if you go back to the early 1930s, Dave, I think we had the same thing happen at Credit Anstalt.

David:  This is the unique thing, Kevin.  We are trying to create confidence in the marketplace by creating these sham tests, saying, “Look at our measure.  By our measure, everything is fine and healthy here.”  If your tests are not legitimately rigorous enough to prove out who are the good bets and bad bets, if your effort is really just to save everyone, again, taking away from that business cyclicality, where the good banks are going to succeed, and the bad banks are going to fail, and the good banks will then come in and buy the assets of the bad bank and they will be that much stronger of an entity moving forward.

Kevin:  It’s like a medical diagnosis.  If you go in to get your physical, you don’t want the doctor to tell you that you are fine, if you are not fine.

David:  “You’re doing just fine (your liver just failed).  You’re doing just fine!”  This is the issue, Kevin.  They set up a sham test, and now have lost credibility, even more credibility, because the market gets to say, “Wait a minute.  Dexia.  You lied.  Erste Group.  You lied.  Well, should we have the same appraisal that we do, in fact, trust you as it pertains to other institutions across Italy, and France, and Germany, and Portugal?”

Kevin:  Maybe all institutions.

David:  And that’s the issue.  That’s the issue, Kevin, as we are losing credibility in the marketplace. This, too, is a part of the cycle, a breaking down of trust, until the point where no one has confidence anymore, and the few assets that remain are available, very inexpensively, if you have preserved value, if you have the ability to redeploy from a cash (bullion) position, and move into the companies that survive and will thrive during the next business cycle upturn.  That may be 4-5 years hence, but the proper planning still has to take place today.

Kevin:  Let’s conclude with this, Dave.  We have had a lot of people calling and saying, “Gosh, gold has been awfully volatile over the last 3-4 weeks.”  The early part of August, gold was in the 1600s, and then all of a sudden it went to 1700, 1800, 1900, and then fell right back down into the 1600s.  So it got ahead of itself, probably, but you made a comment to all of us, and I think you probably ought to repeat it to the listeners.  The questions were:  How much further can gold go down?  How much further can gold go up on the short run?  And what are the chances of that, and what are the parameters that we should be looking for from a dollar price range in gold right now?

David:  Just for perspective, I think the listener needs to remember that the gold price has collapsed in the last month, and it is still up 23% from last year this time.

Kevin:  Yes, it started the year at $1298.

David:  The press that it is getting that it’s over, the bull market is over, the bubble has burst – somebody needs to check their facts.

Kevin:  It is the same people who tell us to fear deflation.

David:  It is still up 23% from a year ago this time, Kevin.  I think if we look at the technical analysis, there is 10% downside on the gold price.

Kevin:  Okay, 10% down is a possibility.

David:  With 50% on the upside.

Kevin:  So that is a good bet.

David:  It is a good bet.  If you are 50% downside, 50% upside, you are in no-man’s land.  You have equal probabilities of losses to gains.

Kevin:  Flipping a coin for a bet.

David:  Exactly.  This is 10% downside, moving to the 65-week moving average as an outside possibility.  I don’t count on it.  I wouldn’t look for it.  At our most recent drop to $1531, you were either cotton-pickin’ lucky, or why were you awake at 1 o’clock in the morning in European trade when it reached $1531 and opened the next day considerably higher?  So you may see it go to low numbers, but the reality is, you may not capture those lower numbers if you are trying to pick the absolute bottom.  That is why I think it is intelligent, and mature, for an investor to say, “I don’t have to have the absolute low, I don’t have to have the absolute high.  But if probabilities are in my favor, 10% on the downside, and 50% on the upside…

Kevin:  Then it’s time to buy.

David:  It’s time to buy.

Kevin:  Well, and you would also tell our clients not to buy on leverage or debt, because then the volatility does shake the trees and you have to drop it all.

David:  That is absolutely right.  We are talking about physical metals.

Kevin:  Buying it one-on-one.

David:  Exactly, exactly.  No leverage.  If you are playing leverage in this market, you really don’t understand what this market is about.  This is an unwind of the Western financial system that has been built over a 50-year period, and you don’t know what all the implications are going to be.  What in the world are you doing gambling with leverage?  That makes no sense at all.  That makes absolutely no sense at all.  So for anyone who has a 5-to-1 leverage, 4-to-1 leverage, or 3-to-1 leverage, believe it or not, you’re the patsy.  You may feel like you’re the most intelligent guy, trading your account…

Kevin:  Even if it is gold or silver.

David:  But you are the patsy because you haven’t appreciated just how severe the changes are that are coming, to the whole financial system, and we were privy to some of those changes in our conversation this last week with Franck Biancheri.