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I agree with your commentary, John.

When the financial cooperation stops, next is WWIII

Who can prepare for that?

From Don Luskin -- buy gold.

SmartMoney
Published October 31, 2008
AHEAD OF THE CURVE by Donald Luskin
Inflation, Not Deflation, Is Looming Threat

HERE'S THE DIRTY little secret of all the rescue operations that have been carried out this month by government financial authorities around the world. They all take money. Lots of money. And that money has to come from somewhere.

So when the U.S. Treasury says it will invest $700 billion to support the banking system, it has to be able to issue $700 billion in Treasury bonds. Someone has to buy those bonds. Someone has to think they're a good investment, at a time when most people don't think anything is a good investment. The Treasury's effort to restore confidence in banks depends on people having confidence in the Treasury.

When the Federal Reserve says it will invest $500 billion in the commercial paper to support the short-term financing market, it has to print the money. People have to think that money's worth something, even though it's been freshly printed for the occasion. For the Fed to restore confidence by making money available, people have to have confidence in money.

These two things are closely related. A Treasury bond is an iron-clad commitment to pay interest every six months, and to pay the face amount at maturity. To pay in the form of money, that is. It's a riskless security, because the government has the power to print the money required to make the payments. But if the money is worthless, then the bonds are worthless.

The way the credit crisis has unfolded over the last two years, it seems that the focus of the trouble has moved from company to company, from security to security, from country to country. One problem gets solved, then another one crops up. Like leaks springing up in a dam, they just can't all get plugged. When all the problems have been solved, there's only one place for the credit crisis to go: to money. If that happens, then it's not just another leak in the dam; it's a dam break.

If people lose confidence in money, then it's all over. Money is all the rescuers have. When the money itself loses value, there's no one to rescue the rescuers.

What is money, anyway? It's a claim-check that can be presented for goods and services. If you're Joe the Plumber, then money is a claim-check on your plumbing services. Someone hands you a $100 bill, you have to give them some plumbing.

So the amount of money in the world must bear some reasonable proportion to the amount of goods and services that it might claim, now and in the reasonably foreseeable future. If there's too little money, then there's not enough to buy all the plumbing services that are being offered, and the price of plumbing has to fall. That's called deflation. When there's too much money, then there aren't enough plumbing services to go around, and the price of plumbing goes up. That's called inflation.

See where I'm going here?

The Treasury is borrowing a ton to support this year's stimulus program, the housing bailout, the Fannie Mae (FNM1) and Freddie Mac (FRE2) bailout, and now the banking bailout. It all totals something like $1.5 trillion. The Fed's balance sheet has simply exploded over just the last eight weeks. It's gone from about $850 billion to about $2 trillion.

There isn't enough plumbing in the entire universe to use all that money. The only possible outcome is inflation.

I understand if you think I'm completely crazy at this point. How can there possibly be any danger of inflation whatsoever when the price of oil has been more than halved in the last three months? How can there possibly be inflation when the whole world is suddenly in a deep recession, and consumers have stopped spending?

How can there possibly be inflation when the spread between regular Treasury bonds and inflation-protected Treasurys, or TIPS, has gone negative? It's true. The yield on a five-year TIPS is actually higher than the yield on a regular bond, which means the market is forecasting deflation, not inflation, for the first time since TIPS started trading a decade ago.

That's certainly how Ben Bernanke sees it. In the Fed's public statement this week when it cut interest rates to 1%, it pretty much said that inflation is dead and buried, with a wooden stake driven through its heart.

What can I say? If you believe all that, I'm delighted that you have such confidence. I'm delighted you're so optimistic. Confidence and optimism are in short supply right now, to be sure.

But I think you're wrong. The U.S. Treasury is borrowing so much money — as are the treasuries of all the major countries — in order to support banking rescue operations, there's just no way that bond yields aren't going to have to go up. When that happens, the Fed and the other central banks of the world will probably decide to buy some of that debt, to keep rates low, so that the world can more easily pull out of recession.

That's called "monetization" of debt. It means that, effectively, instead of borrowing real money, the governments of the world will just print it. That always causes inflation. But the governments will do it, because they believe inflation is dead, so they'll think they can get away with it.

But the fact that they think inflation is dead will bring inflation to life. If you print enough money, you will get inflation. No matter how much the price of oil has fallen.

So what if the oil price drops by 50%? If the governments of the world print enough money, that drop won't last long. Neither will the recent drops in other commodities. That's the way inflation works. It's the way it always works. Governments print too much money. The price of everything goes up. That's inflation.

Now I'm not saying it has to rise to crisis proportions. It will happen slowly. A little bit at a time. We'll have plenty of time to see it, and avoid the worst.

But we'll see it later than we should. We'll see the first signs, and the second, and we'll ignore them. We always do. Then it will get worse, and finally we'll react. Hopefully, that day will come before inflation gets so out of control that we really do have a crisis on our hands.

The best way to play it is with gold. Lately gold has been acting more like lead. It's fallen along with everything else. Cash is king right now.

But gold is the single most inflation-sensitive thing in the world. I think before a year has passed, gold is going to start sensing the inflationary threat I'm talking about. When it goes back to the old highs around $1,000, and then just keeps on going, remember: You heard it here first.

http://www.smartmoney.com/investing/eco ... /?cid=1108

I should state that I do not agree with Don Luskin or others that we're entering an inflationary period or that gold will shoot up as a result. I do own some physical gold, mainly as a shit hits the fan type of measure.

I just don't see it. This is anecdotal (and hardly scientific) but I'm Pakistani by birth and still have a lot of family in Pakistan and India and many of my relatives, friends, and friend of friends stopped purchasing gold there a while ago. I think they're the largest purchasers of gold in the world. Lots of people are even using silver (with gold plating at times) for bridal jewelry, which is unheard of.

My reason for owning gold isn't in hopes of a tanking US Dollar....

I have a different reason for holding gold...

I see gold simply as a system or SHTF hedge. If that ever came to be, yes we may be in an inflationary period. I do not see the US Dollar going away any time soon, but I realize there is always a possibility. IF we reach inflation and there is a surplus of dollars in the system and gold goes to the moon ( ) then I guess I can say GREAT, I'm prepared. But this isn't happening now. I believe this simple fact has caused more arguments/anger among the newly minted gold bugs...why?? because all the writers said gold was going to the moon and the gold juniors were a ticket to retirement. While the LOOP is still open, the Peter Schiffs of the world are treading water big time here...

I've always considered holding 10-15% in Gold and Silver Eagles (regardless of price) because gold has been recognized for thousands of years while the dollar is still just another fiat currency. I also realize that 100 years ago, most all currencies were backed by gold and that its a good possibility that one day it could play a similar role. The other qualities (no counterparty or management risk) are other reasons. For me this means I really don't need to follow the gold price or worry about it.

OK, I'm going to ask a really dumb question. I understand the concept of inflation occurring because the government prints more money...but in our US economy, don't most transactions occur electronically? It's hard to imagine a situation where the pay truck would pull up and toss bundles of paper money to workers, like happened during Germany's hyperinflation. How would hyperinflation occur in our economy? (I'm not predicting anything here, just trying to understand a field that is completely new to me.)

John,

There may be a couple of missing components in your argument about deflation and they are the gold standard and regulation! One reason why the Federal Reserve did not act to pump money into the economy was regulation and the amount of credit the Federal Reserve could issue was limited by laws which required partial gold backing of that credit. How do you think this will impact the currency? Is the deflationary spiral so large that no amount of money could be printed to stop it and that it would need some 1000 trillion dollars?

Cheers

TheCoinCollector wrote:John,

There may be a couple of missing components in your argument about deflation and they are the gold standard and regulation! One reason why the Federal Reserve did not act to pump money into the economy was regulation and the amount of credit the Federal Reserve could issue was limited by laws which required partial gold backing of that credit. How do you think this will impact the currency? Is the deflationary spiral so large that no amount of money could be printed to stop it and that it would need some 1000 trillion dollars?

Cheers

Yes.

John

John,

Looks like you have some backing from Fortune and CNN on the deflationary trend - here is a fresh article talking about how central banks are fearful of "the destruction of trillions of dollars in credit" and deflation (which is the outcome of all that destruction.

Here is the link

http://money.cnn.com/2008/11/06/news/de ... /index.htm

Best Regards

Dear Jim,

JimZ wrote: > Looks like you have some backing from Fortune and CNN on the
> deflationary trend - here is a fresh article talking about how
> central banks are fearful of "the destruction of trillions of
> dollars in credit" and deflation (which is the outcome of all that
> destruction.

> Here is the link

> http://money.cnn.com/2008/11/06/news/de ... /index.htm

Thanks for pointing that out.

This morning I heard a lengthy BBC segment on deflation, and how
shocked economists are that the fear of inflation has changed into a
fear of deflation in just a couple of months.

There was also a major NY Times article last weekend:

http://www.nytimes.com/2008/11/01/busin ... ref=slogin

This is actually a major change in attitudes of economists. For
years, economists have considered inflation the only major challenge.
In fact, Bernanke is known to have believed (and perhaps still
believes) that deflation of a "fiat currency" is impossible.
Incredibly, he continued to believe this even after several years of
deflation in Japan.

It's really astonishing to see this. When I was growing up in the
1950s, no one ever worried much about inflation, but they were very
worried about a new Great Depression. That's because those people
grew up during the Great Depression of the 1930s. In fact, my mother
was always worried about it, well into the 1990s.

But today's economists believe that deflation is impossible, and that
the only thing to worry about is inflation. That's because those
people grew up during the ironically named Great Inflation of the
1970s.

As I've pointed out many times, mainstream economists and
macroeconomists are totally clueless as to why any of this happened.
They can't explain why inflation occurred in the 1970s, they can't
explain why, having occurred, it didn't cause a major asset bubble,
they can't explain why the panic of 1987 occurred, or why it happened
at exactly that time, they can't explain why the dot-com bubble begin
in 1995, and why it began at exactly that time, they can't explain
why real estate or credit bubbles occurred (and some are even still
denying that there even was a bubble), and they have ABSOLUTELY NO
IDEA AT ALL how we got to where we are today. All they can do is
throw money at the problem, and they have ABSOLUTELY NO IDEA whether
that's going to work.

And you know what I'm going to say next -- that generational theory
explains all of these things, as I've written many, many times.

** System Dynamics and the Failure of Macroeconomics Theory
** http://www.generationaldynamics.com/cgi ... acro061025

That's why the current change in attitudes of economists is so
significant: Because it represents the repudiation of decades of
mainstream economic "theory."

Accepting the fact that deflation is occurring is no trivial
decision, like picking out the color of your clothing for the day.
It's a major change in direction for mainstream economics, and it's a
complete refutation of much of economic theory as developed by Fed
Chairman Ben Bernanke and others.

They will literally have to change all their computer models, and
rewrite all their research papers and textbooks. This change in
economic thinking is truly historic.

Sincerely,

John

A different article about it:
http://cij.inspiriting.com/?p=549

"...

But the question is how? The case of Japan showed that it is impossible. In that sense, the deflation argument is right. In the current credit crisis in the US, it is impossible to win the war against deflation.

Well, it is impossible unless unconventional means are used. The word “conventional measures” appeared prominently in much of the Fed’s discussion. According to Bernankeism, when the

… powers of a central bank are limited to “conventional measures,” the central bank may not be able to prevent deflation, nor to fight it once it has taken hold. In the Fed’s view, Japan tried conventional inflation measures to their utmost.

What are the unconventional measures that Bernanke advocated?
If you read the Fed’s papers and speeches, you will find a series of “increasingly exotic plans,” from the “merely unsound to the bizarre and terrifying.” For your information, these are not something we invented from our imaginations- they are available in the public domain at the Fed’s web site. The list of references can be found here.
Below are the unconventional measures:
1. Expand the menu of assets that the Fed could purchase through its open-market operations. This measure is already implemented- see New tricks required to bail out financial system.
2. Purchase of long-term US Treasury bonds.
3. Writing interest rate option contracts.
4. Purchase foreign exchange reserves in order to devalue the US dollar.
5. Loan money into existence, accepting as collateral almost any private-sector asset whatever.

So far, the above measures depend on the willingness of borrowers to borrow the cheap money that the Fed prints. What if the private sector refuses to borrow? Well, no worries! The Fed will print and distribute the money (note: this quote is straight from the Fed’s mouth):

One tool commonly attributed to the Federal Reserve, at least in theory if not by the Federal Reserve Act, is that of conducting “money rains”.

Money rains are a clean way to study theoretically the effects of increases in the supply of money. In practice, it seems a bit difficult to envision how the Federal Reserve could literally implement a money rain — that is, give money away either through directly disbursing currency to the public or by disbursing it through the banking system. The political difficulties that are likely to arise from the Federal Reserve determining the distribution of this new wealth would be daunting.

Now, what if the Fed prints and distributes but the people are unwilling to spend? Well, the “next weapon in their arsenal is to make money pay a negative rate of interest.” While that sounds difficult, the Fed has actually written a paper to explain how they are going to do that:

The strategy for eliminating the zero bound, therefore, is to make money pay a negative nominal interest rate, by imposing some type of “carry tax” on currency and deposits

…The technological difficulty lies mainly in imposing such a tax on currency. In the 1930s, Irving Fisher of Yale University, one of the greatest [sic] American economists, proposed such a system, in which currency had to be periodically “stamped”, for a fee, in order to retain its status as legal tender. The stamp fee could be calibrated to generate any negative nominal interest rate that the central bank desired.

What if this still fails to inflate? There is another weapon- the direct monetisation of goods and services (note: this quote is straight from the Fed’s mouth):

Why not have the Fed just conduct an open market purchase of real goods and services? Even more so than exchange rate intervention, this strategy would represent a direct stimulus to aggregate demand.