Will recession kill inflation after all, hurting Gold Bullion owners instead of rewarding them...?
TODAY WE ASK whether we've got it all wrong, writes Dan Denning of The Daily Reckoning Australia.
In the spirit of humility, let's take a moment to examine whether we're simply wrong about our main investment thesis: that the extraordinary measures adopted by central bankers and government officials will result in tremendous inflation, and thus boost commodities and resource shares.
The first strike against the theory is the global recession. It now looks like the global economy will grow much less quickly in 2009, if it grows at all. Investors are busy re-pricing commodity stocks for a world where resource demand drops along with consumption in the developed economies.
But a cyclical recession in resource stocks is a manageable event. The bigger challenge to the inflation argument is, well, deflation. The argument here is that there was simply far more leverage in the system than even we expected. As that leverage disappears – Hedge Funds Selling Their Gold Bets to meet redemptions, for example – all assets fall in value.
So far, it looks like the deleveraging of the global financial system is destroying wealth faster than central banks can create new credit to replace it. Europe organized $1.7 trillion in guarantees on bank loans last week. And in the United States, it won't be long before every institution and every debt is guaranteed by the full faith and credit of the American government.
This should lead to the first trillion dollar fiscal deficit in American history. Heck, it might even be two trillion.
South Korea then guaranteed $100 billion in bank debt this weekend, and provided banks $30 billion in loans, while the Dutch government "injected" $19.6 billion into ING. Yet as large as all these government guarantees and capital injections are, they might not be large enough.
These amounts are small compared to the amount of value already destroyed in the residential real estate market and in the stock market. Twenty trillion has already been wiped off global shares. Property markets in the UK and the US are imploding.
So what we may have underestimated is how quickly this deleveraging and value destruction would spread to the commodity markets, which we thought would provide relative safety with the backing of tangible value. Resource stocks did not hold up for long at all. Why not?
On the one hand, it now looks like a lot of investors were buying commodities – and staying "long" of the trend – with borrowed money. Those investments have now been sold to raise cash and pay back loans.
Secondly, when it's a bear market in stocks, there aren't too many stocks that do well, full stop. Not even Gold Miners against the backdrop of Gold Bullion holding up well...or at least, not collapsing alongside everything else.
But isn't inflation in tangible asset prices just a matter of time as the global money supply grows to reflate credit markets? And what about all the new government loan guarantees and capital injections? Don't they have to be inflationary, too?
Well, if governments borrow to finance these various programs, they'll issue new bonds. Bonds soak up the available pool of global savings. To that extent, this new borrowing crowds out other ventures, which might otherwise have put the savings to a productive use. But financing the scheme with bonds is not, at least, right away, inflationary. Not in itself.
However, if governments can't find takers for the bonds they issue to finance these schemes, they will have to either raise taxes (not likely in a recession) or simply print the money.
And here's a hint. That's what they always do, from Argentina to Zimbabwe.
That is why we maintain the preferred response to huge debt levels is outright money-printing. Besides, simply making credit more available by lowering interest rates stops working after awhile (like when you can't lower rates any further...and become zero bound). How do you get available credit out of bank computers and into consumer wallets? It's not easy. Bankers are suddenly quite shy where they were once promiscuous.
Then you have to get people to spend the money instead of stuffing it under their mattresses. The banks have been stuffing their money in mattresses; overnight accounts with central banks have swelled to record levels. So now, governments are simply taking over the banks. Let the new loans begin!
This government nationalization of the banks solves another problem with run-of-the-mill credit creation. You can make the credit flow, but you can't always determine where it goes. In these unusual times, however, the government is now in the position of deciding where it wants the money to go.
Right now, all this government cash is simply shoring up bank balance sheets with more capital. But to really "get things going again" and "fight the recession", the money will have to get back into the real economy. And this is where we see the inflation coming. Not in asset prices for houses or shares. But in real goods. Why?
If the government engages in massive public works projects as a way of stimulating demand in the economy and keeping up growth, it's going to be resource intensive. In a way, this is just another kind of phony boom, but with the free-market varnish stripped off to reveal it as an über-lending program by some kind of pan-governmental agreement worldwide.
It's clear, of course, that we just had one simultaneous global credit bubble. Now we're getting the mother of all government debt bubbles to follow up. Only this one will not simply be a collection of various national bubbles. Instead, it looks like we're going to get a kind of Global New Deal. And that's because leaders want to defeat recession – and the threat of depression – by doing "whatever it takes," as the UK's Gordon Brown keeps repeating.
Western governments are already suggesting a system where the world's top thirty banks will operate under the supervision of a government panel of some sort. You'll see more "super banks" and greater control of the levers of global banking too, plus a concerted program to flood the world with new fiat currency.
Quite how this prevents future bubbles or leads people away from their addiction to debt, we're not sure. But we're pretty sure it's not a promising development on either score.
As for inflation, we believe it's coming. Gold Investment, oil, copper and basic foods look sure to go higher, we think, on this flood-tide of new fiat currency.