Purchasing Power Of Gold During Cycles Of Inflation And Deflation

by: Michael Filighera

October 23, 2011

Gold Remains In a Correction Within a Longer Term Bull Market

Fact or Fiction

Discussions on gold usually center on its “bubble status.” Is it in a bubble? Has the bubble burst? Is it reacting to inflationary pressures? Deflationary pressures? Is it really a trusted storehouse of value? What do I get from owning gold? Many questions and just as many opinions are given as answers.

Bitten by the gold bug back in 1979, I have observed first hand the parabolic rise to $850 in 1980 and have researched through years of historical data charting gold prices (by hand for many years) ever since. I watched as the Central Banks of England, Germany, France, Ireland and several other countries sold their gold reserves at the 1990 lows ($253) in preparation and acceptance of the European Rate Mechanism (ERM), a fiat currency based system. The ERM was put in place to establish monetary equality amongst EU member states in preparing for the arrival of the euro as a unified currency.
Inflation or Deflation – the Who, What, Where, and When

A major sea change has been and remains underway in the global investment markets since the late 1990s. I am not attempting to stir the hornets’ nest or play devil’s advocate, but it is a plain and simple fact. One that some have embraced and others continue to deny.
The deadly combination of financial and currency declines (collapses) that began in Thailand in 1997 and more recently in Iceland, Greece, Ireland, Spain, Portugal, and Italy, – has punched holes into the economies of the countries involved. Debt defaults, banking problems and deflation – yes deflationscar and change the global economy moving forward. It is the primary reason behind the bull market in gold and the primary reason it will continue to support gold’s upward momentum.

What is true inflation and true deflation? One would be hard pressed to find an established industry wide accepted definition. According to Robert J. Barro and Vittorio Grilli from their 1994 publication, 'European Macroeconomics'', “deflation is a decrease in the general price level of goods and services.” Simple enough right – I don’t think so. Deflation results as well when a shift in the supply and demand for goods and services happens.

A friend and valued colleague Dan Ascani has written volumes on what true deflation and true inflation are. To begin to understand these terms, acceptance that both are monetary phenomena is important and should be viewed within the context of a fiat currency system.

From the reportGold In A Deflationary EconomyDan explains:

Inflation is a monetary phenomenon and occurs when too much money is created and prices rise. Money can be created not only by an expansion of the monetary base by a central bank through its open market operations, but through an increase in bank lending. In other words, every time a bank lends money, the total money in circulation in that country increases since, in the U.S., for example, Federal Reserve-dictated bank reserve requirements typically require a bank to have on deposit in its vaults only 10% to 15% of the amount of a loan that is created. When long-term prosperity has been experienced, overly optimistic banks tend to lend too much money to customers. Thus, inflation is not just a situation in which commodity prices rise, but a situation that occurs within the monetary base of a country.

On the other hand, deflation occurs after too much money has been created by excess lending and borrowers cannot pay back their loans. The resulting defaults are, therefore, deflationary because the money that the bank created through its loans was not paid back, and money circulating in the monetary base is destroyed. Thus, bank loans and inflation create money, and debt defaults and deflation destroy money. When money is destroyed, it is literally taken out of circulation – the opposite result from that of loan creation.

Whatever the case, the definition, or the esoteric monetary conditions, one thing is true throughout the over four centuries of wholesale price and gold data: gold is absolutely a long-term store of value that survives periods of inflation and deflation alike "the only item that has survived all of time, all governments, all types of economies, all economic conditions, all panics, collapses, and crashes, and all wars, while still maintaining its long-term purchasing power.

This is not to say that there haven’t been periods where gold has lost value, on the contrary history reveals long periods of sinking gold prices, but through each of them gold always returns to its relative value as expressed in terms of a basket of commodities.

Roy Jastram’s 1977 book 'The Golden Constant ' has become the authoritative research book on gold. Spanning 438 years of economic up and down cycles this classic is now available in PDF format after being out of print for many years. Jastram’s influence in transforming many from speculative thought to factual information is undeniable and his work(s) are quoted and used to support various theses worldwide.

Jastram’s study is a masterwork demonstrating with clarity the behavior of the purchasing power of gold in periods of inflation and deflation and in a historical context judging as to what extent gold served as an inflation hedge or as a means to conserve wealth in periods of deflation. It covers the English experience from 1560 (the year of the Great Re-coinage in England) and the American experience from 1800 (the beginning of consistent data in America).

The entire 438 year study can be categorized into periods of inflation and deflation. Although Jastram’s study takes us through 1976 several respected analysts have updated Jastram’s work through current times.

Period 1: Deflation of 1814 – 1830

Lasting 16 years the purchasing power of gold increased 100% while commodity prices declined 50%. Imports flooded the domestic markets creating widespread unemployment. By 1818 credit had contracted to extreme levels forcing landowners to sell their properties. The gold standard was the monetary system in use.

Period 2: Deflation of 1864 -1897

Lasting 33 years the purchasing power of gold increased by 40% as commodity prices declined 65%. The U.S. Civil War not only divided the country but sent prices sharply higher as severe inflation gripped both the north and south. The south saw a complete collapse of its currency and government financial system which brought the entire country into depression until 1879 when the Gold Standard was re-established after being abolished at the start of the war in favor of a fiat system.

Period 3: Inflation of 1897 – 1920

Lasting 23 years saw commodity prices increase by a staggering 232% while the purchasing power of gold dropped 70%. Within this period, from 1897 -1914, was a smaller period that many economists called “the classic gold standard.” During this time, institutions that issued money were required to hold sufficient gold reserves to meet any and all redemption demands. As with the Civil War, the beginning of World War I and increasing inflation proved that gold is not always the best inflation hedge.

Period 4: Deflation of 1920 – 1933

Lasting 14 years the purchasing power of gold increased 251% and commodity prices fell 69%. Global stock market crashed beginning with Europe in 1920. Although it took an additional 9 years to finally hit the United States, the devastating deflationary aftermath threw the world into the Great Depression. A careful study of this period reveals that while gold shares began to appreciate in 1930 it wasn't until 1933 that gold and silver began their respective advances. The monetary system in place was the Gold Exchange Standard.

Period 5: Inflation of 1933 – 2007 (1976 – 2007 updated by Dan Ascani )

Lasting 75 years this period includes some unprecedented times for commodity prices as well as gold and silver prices. Overall commodity prices increased by 1456% and the purchasing power of gold increased by 147%. The monetary system in place was the Gold Exchange System until 1971 when the Bretton Woods Act ushered in government managed fiat currencies. Post Bretton Woods both inflation and gold moved substantially higher. Many feel that this period remains unresolved and its resolution depends on the depth and severity of the deflationary cycle currently in force since 2008.

Period 6: Deflation of 2008 - ??

The chart below dates back to 1861 just prior to the start of the deflationary Period 2 and shows in graph form the purchasing power of gold during Periods 25. Interesting to note; when adjusted for inflation the current bull market (and record highs basis the U.S. dollar) has yet to exceed the highs seen in 1980 when the unadjusted high was $850.

Source: www.thechartstore.com

Expectations for the near to midterm:

Plucked from the Seeking Alpha headlines on Thursday, October 20, 2011:

The next big bubble: The amount of student loans taken out last year crossed $100B for the first time, and total loans outstanding will exceed $1T for the first time this year. And just like in the last subprime bubble, lenders have been "pushing loans to people who can't afford them." When borrowers are tapped out, and lenders plead ignorance, who will again be forced to pay for the bailout?

If you were thinking it was safe to get back in the waterthink again! It only gets more confusing from here as we move from bubble to bubble. From deflation to inflation and back to deflation again. As the middle class is vilified and penalized for attempting to gentrify broken down inner city neighborhoods devastated by years of neglect. Many unsuspecting people paid inflated prices only to see the value of their home versus what was owed to the banks go in reverse as the subprime debacle sent real estate prices into a downward spiral.

Foreclosures skyrocketed destroying for many the dream of achieving financial security through home ownership. Corporate greed moved to unprecedented levels as C-level egos justify accepting and paying out multi-million dollar contracts and tens of thousands of lower level employees are laid off and the government (local, state, and federal) turns a blind eye to all as it sinks deeper into the dark cesspool of empty promises and corruption.

The global economic problems so long ignored and swept under the rug have come home to roost. I don’t believe there are any quick painless solutions. It took decades to arrive at this point solving the problems and implementing solutions should not be expected to miraculously turn everything around in a month or two. It will take years.

Accepting reality and being prepared removes fear from the equation. Making solid and fact based investment decisions has become paramount in creating and protecting wealth. The bottom line here: It’s YOUR money! Who do you think is going to care more about it?

The Near Term Picture for Gold

I do not see the current deflationary cycle ending anytime soon. Interest rates are near zero and expected to remain at current levels into 2013. Inflation worries have evaporated for now and won’t likely resurface until solutions are put in place for the US, UK, and European Union to fix the broken economies. Unfortunately we are likely to see many more defaults (sovereign, municipal, corporate and consumer), bank failures, and currency declines as central banks attempt to “print” their way out of their respective problems. Gold will remain a major hedging source.

Within the precious metals and commodity markets, bull markets normally end with a parabolic thrust into the stratosphere. The monthly chart for gold (below) reveals that thus far the advance has been strong but steady without the parabolic nature to suggest the move is finishing. The fundamentals support the advance continuing. The technical picture, while near term revealing a much needed correction, remains underway that additional upside is likely before the larger bull market is exhausted and complete. Near term then, expectations would be for an additional decline into a cluster of support beginning at 1556.40 through 1535/1534. If this area contains additional selling, look for a smaller rally phase (several days to a couple of weeks) followed by another leg down likely pushing prices towards the next support cluster at 1482 to 1452.

The stochastic, MACD and MFI oscillators have all turned lower confirming the current drop off of the 1826 high. The stoch and MFI oscillators are pointing more sharply down giving support to an additional down leg occurring.

SPDR Gold Trust (GLD)

Expectations for GLD are the same as in gold. There is a cluster of support beginning at 153.60, 148.80, 142.55 and 137.35. Look for downside to be contained at the upper end of the zone before a small rebound rally takes place. An additional down leg should follow and drop prices deeper into the support zone before the larger advance picks up again.

Gold Mining Shares

Year– to–date gold mining shares have seen stronger selling. After producing strong returns on a 2 and 3 year basis, it appears that the correction underway in physical gold has produced some profit taking and portfolio reallocation within gold mining shares. The revere data hierarchy includes 101 companies (international and US based) within the gold sector, including companies involved in mining as well as exploration.


The graph above reveals that versus the S&P 500, gold mining shares have outperformed the S&P 500 over the long term with an impressive 152% return on a 3 year basis vs. 28% for the S&P 500. However, as noted, the S&P has outperformed this sector on a 3 month and year-to-date basis. I suspect though, that this will again reverse once the larger advance is again underway in gold.

Choosing which companies to invest in requires some due diligence. From the 101 companies included within the revere gold mining sector, I narrowed the field to seven. All have a current market cap of greater than $1 billion. The graph below reveals that while most outperformed or kept pace with the S&P 500 the list includes both leaders and laggards.

Kinross Gold Corp (KGC)

Kinross is engaged in the exploration, acquisition and development and operation of gold bearing properties. Clearly a laggard, Kinross remains somewhat of an anomaly. With strong cash reserves and medium to low debt the market continues to hold down prices. Tangible book value is 7.61 (current stock price 13.70 as of October 21st). Market cap is $15.6 billion and Kinross has strong holdings in the U.S., Chile, Russia, and Africa. What may be working against KGC is its relative low dividend yield of 0.89.

Newmont Mining (NEM)

Newmont is a gold producer and as of December 2010 had gold reserves of 93.5 million ounces with mining operations in North and South America, Asia Pacific and Africa. Newmont also has copper mining operations in Indonesia. Current market cap is $34 billion. Newmont trades at a low P/E of 15 as compared to the S&P 500 with a P/E of approximately 23. Current dividend yield is 1.95.

Randgold Resources Ltd. (GOLD)

Randgold Resources Limited is engaged in gold mining, exploration and related activities. As of December 31, 2010, the Company’s activities were focused on West and Central Africa. Thus far in 2011, Randgold has reported very strong year-over-year earnings. For the 2nd quarter 2011, they reported $1.24 vs. 0.38 in 2010 on revenue of $321 million vs. $102 in 2010. With a market cap of just over $9 billion, Randgold trades at a P/E of 44. Estimates are calling for FY earnings of $4.98 vs. $1.14 for FY 2010. A continued rally in gold prices should continue to benefit Randgold. In comparison to the S&P 500, Randgold has outperformed on a return basis across the board.


A discussion on deflationary or inflationary cycles should include a look at the Kondratieff Cycle theory based on Nikolai Kondratieff’s studies of economic, social, and cultural life proving that a long term order of economic behavior was in place and could be utilized in looking forward towards future economic developments.

The take away here is that the Kondratieff cycle is one of debt repudiation. A cycle where credit contracts and asset prices decline rapidly. Basically, the excesses of one cycle (the creation of too much money and credit) can not be sustained. The resolution being debt repudiation, which in turn creates the collapse of asset prices and economies based on capitalism to drop into a deflationary spiral.

 The lessons of the past have been ignored and denied, which can only lead us to the inevitable destiny of repeating history yet again - mistakes and all. Fortunately though, while we don’t have enough power to stop this runaway train, there are steps that can be taken to mitigate the effects and emerge from the cycle bottom, not unscathed but in better condition than the majority.

Underestimating or ignoring the purchasing power of gold or its ability to hedge against deflation is akin to sticking your head in the sand at the beach to avoid being swept away by a tsunami. If gold is already a core holding in your portfolio, you understand the benefits. The opportunity to prepare presents itself almost on a daily basis. Take the time to review your assets and your portfolio, protecting and building on what you have earned is possible. An investment strategy that includes positions in dividend paying industry titans Microsoft (MSFT), Intel (INTC), Walmart (WMT), Coca-Cola (KO), and The Hershey Company (HSY) and deflation hedges (phsyical gold and silver, GLD, Silver ETFs, and gold mining stocks) are prudent and still available. Investors should do their own due diligence in determining what the correct investment is for them.

Hoisington Quarterly Review and Outlook

John Mauldin's Outside the Box

Published 10-17-2011 10:37 PM

Dr. Lacy Hunt and Van Hoisington of Hoisington Investment Management write a “Quarterly Review and Outlook” that is a must-read for me. This quarter they focus on US monetary policy, noting that “After peaking at 1.69 in the second quarter of 2010, M2 velocity declined for four consecutive quarters, and we estimate that a major contraction in velocity to 1.59 is likely for the third quarter.” (I mentioned the importance of the velocity of money in judging inflation vs. deflation prospects in this week’s e-letter, too.)

They say, “If our analysis of a new contraction in GDP is correct, the U.S. economy should be viewed as operating in the midst of a long-term slump, regardless of terminology.”

They borrow a riff from Harvard economic historian Niall Ferguson, who has asserted that the world is experiencing a “slight depression”; and mention that this conclusion has been backed up by Gluskin Sheff’s notable economist, David Rosenberg, who reminds us that “Depressions are basically long recessions lasting three to seven years.”

Hoisington Investment Management Company (www.hoisingtonmgt.com) is a registered investment advisor specializing in fixed-income portfolios for large institutional clients. Located in Austin, Texas, the firm has over $4 billion under management, composed of corporate and public funds, foundations, endowments, Taft-Hartley funds, and insurance companies.

Your kicking up my heels in the Big Apple analyst,

John Mauldin, Editor
Outside the Box


Quarterly Review and Outlook

Third Quarter 2011

Dr. Lacy Hunt and Van Hoisington


Negative economic growth will probably be registered in the U.S. during the fourth quarter of 2011, and in subsequent quarters in 2012. Though partially caused by monetary and fiscal actions and excessive indebtedness, this contraction has been further aggravated by three current cyclical developments: a) declining productivity, b) elevated inventory investment, and c) contracting real wage income.

a) productivity

In the last half of 2010, real GDP grew about 2.%. The consensus forecast for 2011 was for growth to accelerate to 3%-4% due to the massive easing of Fed policy (QE2), social security tax cuts, and other fiscal stimuli. Surprisingly, real GDP growth slowed to less than 1% in the first half of this year. When growth slows abruptly and it is markedly at variance to expectation, businesses find they have more employees than desired. Normally, firms are reluctant to resort to layoffs, but a failure to do so means unit labor costs rise swiftly as output per man hour (productivity) falls. This was exactly the experience in the first half of 2011. In the very broad, non-farm business sector, productivity did decrease at a .7% annual rate. Accordingly, unit labor costs surged at a 4.8% rate over the same time period, exceeding the rise in consumer prices.

Historically, a sustained and meaningful drop in productivity and a parallel rise in unit labor costs have been precursors to increased layoffs as businesses struggle to restore margins and profitability. Once these job losses commence, broad negative ramifications are felt throughout the economy (Chart 1).


b) inventory reversal

Inventory investment, the most volatile component of the economy, has contributed substantially to the recovery since 2009. From the second quarter of 2009 to the second quarter of this year, real inventory investment surged by $222 billion, accounting for 35% of the rise in real GDP over that period. Now inventory investment accounts for 1.18% of real GDP, which is .18% above the average since 1990. In July and August, production of consumer goods increased at a 3.2% annual rate versus the second quarter, while real retail sales contracted at a 1.4% rate; therefore, inventory investment moved to an even higher, likely undesired, level. Consequently, as firms move to rebalance inventories, the stage is set for a slowdown in production, requiring a further need to pare staffing levels.

c) real wages

Real average hourly earnings has fallen by 2.2% over the twelve months ending August 2011. Real disposable income (a broader measure of income) was lower in August than last December. Initially, consumers responded to this lack of income growth by cutting their saving rate back to the recession low of .4%, but now an evident slowdown in spending has occurred. Real spending expanded by only .7% in the second quarter, and remains sluggish in the third quarter. This lack of real income growth will contribute to the negative changes in GDP in coming quarters (Chart 2).


This reduction in real income can be traced, in part, to the misguided attempts to spur economic growth by the Federal Reserve via quantitative easing (QE2). The QE2 expansion in the Fed’s balance sheet backfired as the boost in stock prices (a positive for some consumers) was more than offset by the negative impact of food and fuel inflation on the average family budget. While rising equity values helped a few consumers, inflation in necessities such as food and fuel, decimated real incomes for the average family. Thus, the emergent cyclical weakness that lies ahead can be directly related to the unintended consequences of quantitative easing.

Monetary Policy

Although many measures of economic performance worsened during QE2, the Fed might argue that the recent M2 acceleration may eventually contribute to an improvement in economic growth as deposit growth fuels income expansion. In our opinion, such an optimistic assessment is not warranted.

In the past three months, M2 increased at a rapid annualized pace of more than 20%, and the annual increase in M2 is about 10%, well above the post 1900 average annual increase of 6.6%. This rise in M2, however, appears to reflect a massive balance sheet shift of assets, not a net creation of new assets. Theoretically, if funds are switched from non-M2 assets into M2 assets, M2 velocity would decline and bank loans plus commercial paper would be stable.

This is exactly what has been happening. After peaking at 1.69 in the second quarter of 2010, M2 velocity declined for four consecutive quarters, and we estimate that a major contraction in velocity to 1.59 is likely for the third quarter (Chart 3). Also supporting this idea of asset shifting, bank loans plus commercial paper in September totaled $7.845 trillion, down from $7.906 trillion in June 2010.

In an environment where short-term interest rates are close to zero, commercial paper has become an increasingly unattractive investment since the low interest rates do not cover the risk premium. As commercial paper has rolled off, issuers have been forced to meet funding requirements from bank loans. However, there are other balance sheet changes taking place along with the shift away from commercial paper. With the credit rating of major European banks sliding, companies operating globally may have moved euro-based deposits into dollar-based ones. Supporting this hypothesis, the dollar strengthened during this surge in M2. Economic stresses and uncertainty are responsible for the increased level of M2, not QE2. The real impact of QE2 was that inflation was boosted and real economic growth stunted.

Maturity Extension Program

The initial market reaction to the announcement of the Fed’s latest policy move, known as the Maturity Extension Program (MEP) or Operation Twist, was for commodities and stocks to fall, the dollar to strengthen, and bond yields to decline. Thus, the reaction was to reinforce trends already in place. These market reactions were the exact opposite of what occurred during QE2. Lower commodity prices and the firmer dollar will diminish inflation, thus serving to reverse the drop in real wages that millions of households suffered during QE2. This benefit will not be apparent immediately because the economy has to work through the negative consequences of falling real income and dropping productivity that occurred under QE2. Unfortunately, it is unclear whether Operation Twist will ultimately accrue any benefit to the economy because efforts to achieve very low interest rates could produce counterproductive or unintended consequences.

Banks and other financial intermediaries earn a profit by investing or lending at a rate that exceeds their cost. Due to the low interest rate structure and other considerations, this has become exceedingly difficult, if not impossible. Overnight interest rates are close to zero; thus, to earn a rate above 1% in the treasury market banks must invest at a maturity longer than five years. While this is a positive interest rate spread, all costs may not be covered as banks have to expense payroll, rent, taxes, elevated FDIC fees, and other overhead, and must have a risk or default premium when they lend to a private sector borrower. Therefore, profit erosion of banks and other intermediaries is likely with a lower interest rate structure.

Historical verification of this development is obvious in Japan where more and more of the bank balance sheets have been shifted to government securities rather than to private borrowers. In other words, normal bank lending functions are essentially shut down. This risk now confronts the U.S. with the zero short rate policy and with Operation Twist aimed at lowering yields in the intermediate and long end of the yield curve.

Fiscal Drag

Though budgetary reductions have yet to materialize, fiscal policy via tax increases is also acting as a retardant to growth. The effective tax rate on households can be calculated each month by expressing the sum of federal, state and local taxes as a percent of personal income. From the middle of 2009 to last month, the effective tax rate has risen from 17.5% to 17.9%, a $247 billion tax increase (Chart 4). This rise mainly reflects increased taxation by state and local governments to cover their persistent deficits.

These increases more than offset the first quarter reduction in FICA taxes. Econometric research indicates the U.S. economy will not grow out of the ongoing slump if additional major tax increases are implemented.

In summary, the case for an impending recession rests not only on cyclical precursors evident in productivity, real wages, and inventory investment, but also on the dysfunctionality of monetary and fiscal policy.

Slight Depression

The appearance of a renewed slump only a short twenty-one months after the end of the last recession is highly remarkable. Many statistics support the fact, however, that the U.S. is worse off today than it was prior to the onset of the previous recession. For instance: a) the economy has nearly 9. million fewer fulltime workers employed than at the peak in 2007 (Chart 5); b) real GDP is still below the level reached in Q4, 2007; c) industrial production is 6.7% less than its December 2007 reading; d) real retail sales is $13 billion below its 2007 peak, and e) real personal income (less government transfers) is more than $515 billion below the 2008 peak (Chart 6). The financial markets concur with this “things are worse offidea. The S&P Index is over 20% lower, and bond yields have dropped more than 40% from their peak levels in 2007. Harvard economic historian Niall Ferguson recently noted that the world is experiencing a “slight depression”. This sentiment has also been cogently expressed by Gluskin Sheff’s astute economist, David Rosenberg, who notes that, “Depressions are basically long recessions lasting three to seven years.” If our analysis of a new contraction in GDP is correct, the U.S. economy should be viewed as operating in the midst of a long-term slump, regardless of terminology.


This economic malaise is a direct result of the accumulation of excessive levels of debt and subsequent reduction in the price level of underlying assets. This is a process that U.S. economist Irving Fisher discussed in his 1933 paper The Debt-Deflation Theory of Great Depressions. According to Fisher and confirmed subsequently by Reinhart and Rogoff and the McKenzie Global Institute, a long period of time is required to unwind previous borrowing excesses. These views were recently econometrically verified in a September 2011 publication by the Bank for International Settlements entitled The Real Effect of Debt. This article, authored by Stephen G. Cecchetti, M. S. Mohanty and Febrizio Zampolli, stated, “Debt is a two edged sword. Used wisely and in moderation, it clearly improves welfare, but when it is used imprudently and in excess, the result can be disaster. For individual households and firms, over-borrowing leads to bankruptcy and financial ruin. For a country, too much debt impairs the government’s ability to deliver essential services to its citizens. High and rising debt is a source of justifiable concern.”

Global Debt

We have assembled, with support from Capital Economics in London, foreign debt to GDP ratios that are comparable to the U.S. debt to GDP ratio. The debt figures in these ratios include both private and government debt; thus, they are measures of aggregate indebtedness. These statistics indicate that the euro currency countries as a group, the United Kingdom, Japan and, interestingly Canada, are all more deeply indebted than the United States. This should not give the U.S. solace, nor detract from our severe problems. However, the greater debt in these areas may serve to provide backhanded support for the dollar. More critical is that all major countries are destined to experience slower growth because of excessive indebtedness.

The latest readings indicate that debt to GDP ratios are about: 450% for the Euro zone and the United Kingdom; 470% for Japan, and 410% for Canada. Thus, the Euro Zone, UK, Japan,and Canada ratios are 100%, 100%, 120%, and 60% higher, respectively, than the U.S. debt to GDP ratio of 350%.

We would like to be able to extend this analysis to China because of its rising importance on the global scene. While the Chinese don't provide these statistics, a new book Red Capitalism: The Fragile Financial Foundation of China's Extraordinary Rise by Carl E. Walter and Frasier J.T. Howie (John Wiley, 2011) sheds light on this issue. Carl Walter holds a Stanford Ph.D., is fluent in Mandarin, and resides in Beijing where he has lived for two decades. Walter and Howie acknowledge that China's model has produced super growth, lustrous office towers, massive, grand new airports and other visible signs of wealth and success. Their disquieting theme is that beneath this glamorous veneer the growth model is flawed and fragile. Specifically, they argue that indiscernible, substantial risks are accumulating in the Chinese banking system--in other words, over-indebtedness.

The Bond Market

During the latter part of the 19th and the early 20th centuries the construction of the Trans-Continental railroad created an excessive accumulation of debt. The result was a period of low interest rates when the long treasury yield averaged less than 2.% for more than a decade. In a parallel case, the highly-indebted Japanese economy has seen its thirty year bond yield average about 2% or less since 1998.

In view of the United States extreme over-indebtedness, we believe that 2% is a an attainable level for the long treasury bond yield. In the previous historic cases yields tended to remain close to their record lows for an extended period of time, coinciding with a long period of deleveraging. Presently the U.S. is in its fifth year of deleveraging, and patient investors in the long end of the treasury market have been financially rewarded. We continue to hold long positions in thirty-year treasury debt, but remain increasingly wary of the potential for further adverse meddling by Federal Reserve authorities.

Van R. Hoisington

Lacy H. Hunt, Ph.D.