Deflationists argue that when debt is issued at increasing levels, there comes a point when we simply cannot service the debt, and we have to resort to selling everything we have - bonds, stocks, houses, cars - to raise dollars to pay the debt. In this scenario, deflation occurs as money aggregates, shrinks by debt repayments, people hold off purchases knowing goods will get cheaper and workers will be laid off due to lacking demand.
Four years ago when the Dow was at 8000, I talked to Mr. Ian Gordon, whose 1000 Dow target was predicated on this premise. His idea was to buy gold because it's the ultimate money during times of world depression and deflation.
Well, he was wrong on the Dow, but he was right on gold albeit for the wrong reason. Gold rises in tandem with rising fear of price inflation, not fear of deflation; gold and deflation simply do not go together. Why would you buy gold when your dollar is appreciating in value?
Depressionists often hinge on a back-breaking straw; an event that triggers the debt implosion, with the world blown back to stone ages with riots and violence. I like to bring up two contrarian points to this view:
1. The worst possible event that could trigger debt implosion has already occurred. The world has gone on with business as usual.
In the last 4 weeks, we have witnessed the worst financial event over the last 50 years in the US. The subprime mess shook the US financial system to the core, as it directly affected the marketability of the $30 trillion+ US debt market.
Would you touch beef (US debts) again knowing there is a significant quantity of mad cow disease (Subprime) going around?
The significance of this event dwarfed 9/11, Long-Term Capital Management (LTCM) or the more distant events of the 1987 crash and the 1970s oil embargos.
To avoid the default of 10 million households and the collapse of major banks such as Countrywide, the Feds and the US government will have to step in and bail them out, i.e. forgive the loans with the aid of a broken government printing and borrowing money. Investors see such an inevitable and destructive path for the dollar, so it should be no surprise that gold has broken through $700 and oil has reached a new high.
2. Debt is a man-made virtual feature with limited, localized effects on earth. The world is forever going forwards, not backwards. It is important to remember debts are man-made features, existing in a virtual world, serving to facilitate the transfer of ownership of real assets. While debt implosion may cause localized social instability, it does not affect technological advancement, intellectual development, or the existence and preservation of hard assets.
In my view, the dollar's loss of its reigning status will mildly and swiftly affect the global economy, as the loss of purchasing power by the dollar will merely facilitate transfer of wealth of dollar holders to other fiat currency holders, and the owners of hard assets. If the party has to end for the dollar, it just means that the party is starting somewhere else.
I just landed in Thailand for a three day break and the passport lines are full of hundreds of mainland Chinese. What subprime problem so they say?
Gold has risen from $250/oz to $700/oz in 6 years while global economy has grown the fastest since World War II according to the Financial Times. This goes to show that a Gold bull and prosperity can happily co-exist without a doom and gloom outcome.
In conclusion,
depression and deflation = no;
gold and global prosperity = yes.
John Lee, CFA
johnlee@goldmau.com
www.goldmau.com
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