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Gold, the Dollar and deflation

What next for the Dollar – and gold – as the Fed fights the threat of deflation...?

MANY, MANY times we have opined that the Federal Reserve would not fight inflation at the expense of growth – and that proved true last week.

   This concept permits a measure of inflation and it permits the issuance of money heading overseas to promote world growth. In paying for US imports this way, the authorities believe they're involved in "stable" money creation. But as we are all aware, the over-issuance of money – supplying more than necessary to provide just the right amount of the medium of exchange to make the economy function with stable prices – has now had a long history. This history is likely to get longer, too.

   If this money creation were simply to facilitate global growth, there would be no reason to doubt the value of money. But the temptation to print too much has caused the gold bull market to steadily continue since 1999. With recent events pointing to inflation and uncertainty, it is set to continue for a long time.

   The issuance of liquidity should promote stable money expansion, but it has gotten out of hand. Now over issuance has set off two dangers:

  • Asset bubbles burst where prices have over inflated. This sends asset values plummeting, equaling the disappearance of money;
  • Deflation begins where prices drop, again equaling the disappearance of money.

   If these are on a small scale, the two problems can be coped with. But if they are on a large scale they threaten not only growth, but they can cause a slide down towards depression. This is where confidence in money and the central banks issuing it play a key role.

   Falling confidence can lead to consumers saving, rather than spending their money, and that is deflationary. When consumer's credit becomes suspect, then the institutions behind them become suspect in the eyes of other institutions as well. As recently as a month ago, professional finance people would have laughed at that possibility. But the turmoil in global markets proves the scale of this risk.

   When this second type of money deflation sets in, central banks have to act defensively and issue money. The word defensively must be emphasized, because if they don't act, then deflation really takes off.

   Of course, such deflation feeds on itself, so when new money arrives to combat it, it causes prices to rise as well, prompting the need for an even greater supply of money. This prompts further price rises – meaning a greater need for money – and then price rises again until central banks have to allow runaway inflation. This eventually leads to hyperinflation or a collapse such as can be seen in Zimbabwe today, and as was seen in the Weimar Republic after the First World War.

   Last month saw the beginning of the second type of liquidity supply, an overtly defensive supply from the US Fed and the European Central Bank. Unless they can restore underlying confidence in the system – as well as confidence in the Dollar – they will have to repeat such measures again. The loss of confidence will result, once again, in the starvation of liquidity.

   What makes this defense so critical is the concept of syndication. When a bank wraps up a parcel of dubious mortgages, collateralizes them – and adds its name to them – and issues shares in these instruments to their subsidiaries and clients, they effectively lay off their bets, just look a bookmaker hedging his position on a horse race. Selling portions to several other banks, banking in this way becomes like a spider's web of shared risk. A shock at one point sends waves throughout the banking system, just as we saw last month.

   So if greater Fed and ECB defense is needed, it has the potential to actually break confidence and rocket deflation as loss of confidence in the entire structure of the economy accelerates. The delicacy of such confidence building makes this the most difficult task a central banker can face.

   If it precipitates the need to supply huge doses of liquidity supply, which are confidently accepted – if only out of relief – then the cycle will begin as we described above and growth may be maintained. But the threat of a depression will sit in the wings constantly. However, the task of fighting inflation will then become impossible.

Global cost
   In a local context such hyperinflation can be contained and stopped, because the government has full control of the domestic situation. Additionally, there is always an underlying reason that permits hyperinflation in the first place, but with the global economy fragmented by a host of separate national interests, this is not the case. Hence the greater danger.

   If excessive defensive doses of liquidity are injected, and not just inside the United States, they will have to be matched overseas as we saw in Europe when the ECB also defensively issued Euros to support the continent's banking system. As this happens, surplus holding nations will seek to either quarantine themselves from the local impact of the Dollar's changing value – including reverse capital controls, such as China's new permission to store the Dollar proceeds of export sales offshore – or to switch out of the greenback altogether.

   This will also encourage international trade to be priced in currencies other than the Dollar. Both moves spell disaster for the Dollar's role as the global reserve currency.

The impact on Gold and Silver
   Well before such inflation takes off, the value of the Dollar will plummet. As it is the globe's pivotal currency, on which all others are in some way dependent for their stability, the infection will spread and undermine the entire global money system.

   This is where the meaning of gold and silver as "safe havens" will be properly understood. It is in this climate of doubt and uncertainty that gold and silver investments really prosper. By this we don't expect gold and silver to become "mediums of exchange". But on the one hand, they will act as preservers of value. On the other, they will act to restore confidence in certain paper currencies under stress, in their role as important reserve assets.

   Before that happens, the dust has to settle on the present crisis. Institutions have to take stock, re-strategize, and then focus on the way forward – with precious metals in more favor than before and Gold Buying set to rise.

   Last month's confidence crunch was the beginning of gold and silver's real rise, and it will go on as long as doubts are thrown at the monetary system and the global imbalance of payments.

   Gold Prices, along with silver, will reflect the decay in steadily and sometimes dramatically rising prices. Let me re-phrase that: gold and silver will reflect the decay of the Dollar and its value, taking more cheapening dollars to buy gold or silver. Those fortunate enough to have gold or silver – and this is where Physical Bullion is more precious – will have an element of security that will take them through the dramas coming soon.

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JULIAN PHILLIPS – one half of the highly respected team at – began his career in the financial markets back in 1970, when he left the British Army after serving as an Officer in the Light Infantry in Malaya, Mauritius, and Belfast.

First he worked in Timber Management and then joined the London Stock Exchange, qualifying as a member and specializing from the beginning in currencies, gold and the "Dollar Premium". On moving to South Africa, Julian was appointed a macro-economist for the Electricity Supply Commission – guiding currency decisions on the multi-billion foreign Loan Portfolio – before joining Chase Manhattan and the UK Merchant Bank, Hill Samuel, in Johannesburg.

There he specialized in gold, before moving to Capetown, where he established the Fund Management department of the Board of Executors. Julian returned to the "Gold World" over two years ago, contributing his exceptional experience and insights to Global Watch: The Gold Forecaster.

Legal Notice/Disclaimer: This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment. Gold Forecaster/Julian D.W. Phillips have based this document on information obtained from sources they believe to be reliable but which it has not independently verified; they make no guarantee, representation or warranty and accepts no responsibility or liability as to its accuracy or completeness. Expressions of opinion are those of Gold Forecaster/Julian D.W. Phillips only and are subject to change without notice. They assume no warranty, liability or guarantee for the current relevance, correctness or completeness of any information provided within this report and will not be held liable for the consequence of reliance upon any opinion or statement contained herein or any omission. Furthermore, they assume no liability for any direct or indirect loss or damage or, in particular, for lost profit, which you may incur as a result of the use and existence of the information, provided within this report.

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