Reflation Redux! And what it means for gold

Gold & silver will benefit as governments fight deflation with inflation of the money supply...

A LONG, DEEP RECESSION – possibly a depression, in fact – is now being forecast across a broad front, says Julian Phillips of the GoldForecaster.com.

But the real picture is different. Governments and central banks are not only committed to doing all in their power to resurrect growth and give their different economies 'traction'...but they have begun the vigorous implementation of reflation.

They will do "whatever it takes" to get growth and confidence re-established globally. In essence, the crisis appeared quickly and devastatingly out of greedy lending by banks loaning to uncreditworthy individuals and businesses. It has to be rectified just as quickly, because banks control the lifeblood of liquidity in the economy, and they will place their financial health well before that of the broad economy and their customers.

Private banks have been saved by central banks to date, but it is resumption of growth and confidence – not healthy banks – that must be achieved first. In the major economic blocs of the world, actions are underway, to differing degrees, to force the banks to lend or risk being bypassed altogether, so that the damage they can inflict on growth, through congealed debt and their instruments, is neutralized.

The banks have made it opaquely clear that they will not lend in such a way as to rectify the underlying crises of a dropping housing market and its ripple effects on consumer spending. Governments do see banks as an obstacle to the resuscitation of growth and confidence, so their powerful influence over the state of the economy has to be reduced considerably before this can be done. And it has to be done before any semblance of recovery can be achieved again. The longer the process takes the more difficult and lengthy the solution will be.

Just take a look at the world's three main economic bloc's efforts at stimulating growth again:

CHINA SAYS it will spend an estimated $586 billion over the next two years, roughly 7% of its gross domestic product each year, to construct new railways, subways and airports and to rebuild communities devastated by the May 2008 earthquake in the southwest.

Their reasoning? "Over the past two months, the global financial crisis has been intensifying daily," the State Council said. "In expanding investment, we must be fast and heavy-handed."

But in China, much of the capital for infrastructure improvements comes not from central and local governments, but from state banks and state-owned companies that are told to expand more rapidly. China maintains far more control over investment trends than the United States' government does, so they can unleash investments to counter a sharp downturn.

The Chinese government said the stimulus would cover 10 areas, including low-income housing, electricity, water, rural infrastructure and projects aimed at environmental protection and technological innovation, all of which could incite consumer spending and bolster the economy. The State Council said the new spending would begin immediately, with $18 billion scheduled for the last quarter of this year. In addition, China has already announced a drastic increase of the minimum purchasing price for wheat from next year, by as much as 15.3%.

There is also going to be a substantial increase of the purchasing prices for rice, said the National Development & Reform Commission. In the meantime, they also announced plans to stabilize prices for fertilizers and other agricultural means of production, to ensure that the grain price increase will not be eaten away by input making the price increases real income gains for farmers. This will shore up domestic demand and head off any social unrest in the rapidly growing economy. The government there sees its task to harness all sides of the economy to produce growth while they pull their 1.4 billion people out of poverty. Their recent history confirms their ability to succeed!

IN EUROPE, with its more socialist environment than the USA – meaning greater central government control over the economy – we believe that after bailing out so many banks, a very heavy pressure will be put on commercial lenders banks to vigorously lend down to street level again.

French president Sarkozy's threat to seize banks that don't lend gives meat to this forecast. In Britain, nationalization lies ahead for suffering banks, plus the end of senior executive careers, if they don't lend freely.

Despite lacking the same effective management of the economy in Europe as in China (ignoring politics and commerce and other capitalist principles), governments will act in the same way as the Chinese are, eventually, to make growth and confidence rise again. They are committed to this, at last. So 2009 will be the year of reflation in the face of deflation.

The UNITED STATES will see such a synthesis of national institutions, working together to fight deflation, highly unlikely. The necessary cooperation of banking and commerce to focus on the underlying economic crisis would barge into so many valued principles fought for long ago. However, we have no doubt that the intransigence of such principles in the face of a decaying economy will produce overwhelming pressures on the system to revitalize the consumer and restore his spending.

The US government has now seen the banks follow the "profit and prudence" principles after their bailouts. They're holding back on lending to safeguard themselves, first and foremost. Secretary Paulson has now faced off with them, and redirected efforts to make government-provided financial relief go directly to the consumer. But he is only at the beginning of this process, which must be across the entire spectrum of consumers, not simply a portion of the largest mortgage providers' clients, Fannie Mae and Freddie Mac.

Indeed, the slow nature of this solution as it wends its way through the political and financial obstacles it faces could produce a near revolutionary climate, until sufficient action is taken to re-finance the economy from the consumer-level upwards. After all, day-by-day, solid US citizens are being impoverished by the financial sector's problems, not their own. As slow as the pace of support becomes, the more degenerative impact it will have on uncertainty and confidence.

We have no doubt that 2009 will be remembered as the year of reflation in the face of deflation. Already, house-owning households are likely to receive direct financial aid if their mortgages are more than 38% of income. If this is applied to all US households in this position, we fully expect to see hope lead to confidence, then spending, then growth. These measures – plus the suggested support of the consumer on car finance and credit cards – will re-kindle spending and the economy.

Such moves must convince the US consumer and stop him thinking like a victim. (In the Depression of the early Thirties, the US used – as part of its battery of tactics – paying people to dig holes and fill them in again, just to get money flowing from ground level up!) Similarly desperate programs can be implemented in the next few months and impact on the broad economy by the end of the first half of 2009, if applied properly, as government implies it wants to. If it is, then the first 100 days of President Obama will indeed be a honeymoon.

Over at the Federal Reserve, meanwhile, Ben Bernanke – as well as the governments of the Eurozone and China – have recognized in no uncertain way that confidence must be rebuilt before growth gains traction and becomes self-sustaining. It appears they have got the message now, and will do whatever it takes to ensure the credit crisis is replaced by confidence in credit. That the banks should suffer for their indiscreet past behavior is just. A lender should carry the same risk as a borrower.

Reflation is vigorously being implemented across the globe, but inevitably it will come with inflation. It is impossible to say just how much money needs to be printed to counter deflation, but for sure it will be more than even the current strong levels – and it must keep flowing until the financial sun is shining again. 2009 will probably not see inflation rise to dangerous levels, because of its absorption by the deflationary pull of falling asset prices and retreating commodities. But as the new money fills the deflationary holes, it will spread far and wide and eat into the value of debt, so bringing relief to troubled debtors in addition to direct governmental support.

This will be found to be politically acceptable and will delay, if not remove, the pernicious impact of bad debt that we are seeing now. Growth and confidence are considerably more important problems than inflation. Banks have been given debt relief already and so will the consumer, because that is the only solution to the credit crunch. It will be accompanied by the cheapening of money, leading to far higher gold and silver prices than we are even contemplating now.

As this is slowly realized by an ever-widening audience across the globe, Gold Bullion will re-enter the mainstream of investments as an anchor to monetary values if only at individual levels. Thereafter institutions and perhaps central banks, will appreciate it fully.

Governments have to act very fast to stop the confidence-sapping impact of deflation from becoming a way of life – just as borrowing was over the last thirty years. Consequently, we should expect global stimulation to be put in place before the end of the first quarter of 2009. In that time we fully expect forced selling of all assets to slow to a trickle. Thereafter a positive tone will benefit Gold Prices and silver in the long-term, as well as short-term.

Let's be clear though, there is no historic precedent to what we are about to see. We expect gold to thrive in an atmosphere of hope, against a threatening backdrop, with the gold price realistically discounting the diminishing buying power of paper currencies.