The Deflation Inflation debate continues. If you choose believe the establishment, those same folks who told you there was a new paradigm and that the Dow was destined in few short years to reach 30,000 on its way to 100,000 go right ahead. Those folks, led by the Federal Reserve officials have said that the Fed can and will one way or another inflate the U.S. debt burden away. For reasons I talk about almost every week, I'm not buying the notion that the Fed is this powerful institution that can defy all the laws of economics. I'm not buying the idea that having lived way beyond its means now for the past several decades that the most massive debt burden in the history of the universe can simply be inflated away by a pump priming Federal Reserve that monetizes anything and everything that exists on the face of the earth.

James Sinclair has come down on the side of those who believe the Fed can always avoid deflation by printing money. If they literally print without corresponding entries on our fractional reserve banking system, I am inclined to agree. In other words, if the Fed or some government agency literally prints $100 dollar bills and then distributes them by the truck load to Americans door to door, but makes no corresponding debt entry on the books of our banking system, we could inflate, just as surely as if the Mafia did the same thing in mass. But this would be a last gasp Weimar Republic type of throw in the towel tactic.

I don't think the Fed believes it will have to resort to such extreme tactics to inflate the U.S. economy. But as I look at history, I think it is telling us there is simply that we have now passed the "threshold of debt lethality." In other words, the only thing that can cure the existing ills of mal investment (caused by excessive creation of money and credit) and the debt that has been created in the process of "printing" this enormous amount of money can only be cured by time and a hands off policy of the government. The markets must be returned to equilibrium. Trouble is that is a very painful process and no politician can be seen not to do something to fix the problem. So the Fed makes promises that they can inflate our debt burden away.

Part of the difference of opinion between those who think the Fed can revive the economy and those of us who do not think so is that one of interpretation of history. James Sinclair says that the gold clause that was in place back in the 1930's kept the Fed from increasing the money supply as required. Now that there is not gold clause in place, the Fed can print endless amounts of money so that they will this time be able to reflate. Trouble is, according to Murry Rothbard's "The Great Depression," the gold clause of the 1930's did not in the least hamper the expansion of money and credit during the 1930's. The Fed did in fact pump money into the system such that interest rates were drastically lower during 1930.

But that remedy was ineffective not because of the gold clause but rather because banks would not lend and businesses would not borrow. Britain going off the gold standard in 1931 also contributed to the problem because this led to a lack of confidence in the U.S. dollar which in turn meant that folks began to withdraw their money from the banks, causing a run on the banking system. But the basic problem was that the bubble economy had lead to structural problems which in turn made it impossible for participants in the economy to invest in capital equipment and labor which in turn meant the Fed was powerless to expand the money supply and inflate the U.S. out of the depression. I believe this is very nearly what is happening in the U.S. and throughout the world in 2003 and that as a result, the Fed will not be able to inflate us out of the deflationary depression which in my view and in the view of Ian Gordon as well, is in the very early stages.

This past week, Dr. Stephen Roach, Chief Economist at Morgan Stanley also voiced some skepticism about the ability of the Fed to inflate the U.S. economy. And then, even if they are successful, they will only be serving to create and even bigger problem in the future. Here is a portion of Dr. Roach's essay published on January 21, 2003.

"Reflationary policy actions are widely viewed as the antidote to America's malaise. The key assumption of this argument is that such policies work -- that there is traction between fiscal and monetary stimulus and the real economy. While recent experience argues in favor of such an outcome, the legacy of post-bubble economies does not. In that vein, I continue to believe that policy traction in the US will prove to be disappointing in 2003 (see my 13 January essay, "Policy Traction"). The US economy is lacking in three key preconditions that have enabled policy stimulus to work in the past: Pre-recession excesses have not been purged; the upside of the inventory dynamic is largely complete; and pent-up demand for items such as cars, homes, and capital goods has been spent. Policy makers often end up "pushing on a string" in post-bubble economies. That's been the case in Japan over the past 13 years, and it's also been evident in the US over the past couple of years. Those risks are not about to vanish quickly. Even as the authorities now contemplate actions that up the ante on reflationary stimulus, I continue to believe that America will have a tough time achieving policy traction over the next couple of years.

"Which takes us to the biggest risk of all -- deflation. Another dip alert is an unmistakable footprint of an anemic recovery. And it is a basic macro truth that sub par economic growth -- anything materially less than 3% in the US these days -- is a recipe for rising unemployment and ongoing disinflation. Sub par growth widens further the gap between aggregate supply and aggregate demand. For a US economy that currently has a wide "output gap" and is already closer to deflation than at any point in half a century, that's hardly a trivial consideration. Against the backdrop of structural deflationary pressures -- globalization (in services as well as goods) and lingering post-bubble excesses of capacity -- the lack of cyclical vigor is all the more disconcerting. That's why the authorities are pulling out all the stops to boost aggregate demand. Yet a dip-prone US economy that fails to respond to such reflationary measures - precisely the risk, in my view -- will continue to slide down the slippery slope of deflation. In this context, the last thing the US or the world needs is another dip, or persistently sub par economic growth.

"Yes, the authorities are now doing their best to rise to the occasion, especially in the United States. But the pitfalls of policy traction raise serious questions in my mind as to the efficacy of those actions. Yet the policy ploy is worrisome on a more fundamental count: It is attempting to jump-start a US economy that cannot afford a return to sustained rapid growth. That's right, a prolonged vigorous upturn in America would undoubtedly come at the cost of even more consumer indebtedness, lower national saving, and an ever wider balance-of-payments deficit. The return of the dip is yet another warning that the bill for excess is now coming due. Will we ever heed this warning?"

BULLISH MARKETS

• Commodities - The CRB continues to make new highs. As of Wednesday, it closed at 243.49 and remains near the top of an upward channel that trends back to early 2002 when it was below 190. This index is well above all its short and long term moving averages and as such remains very bullish.



• Gold - is extremely bullish, having broken through its 22 year bear market trend and moving powerfully above its short and long term moving averages. Experienced commodity trader Ron Wolfbauer told today that his near term target for gold is $372



• Gold Shares - The XAU at 77.69 is above its long and short term moving averages. However, the shares have not moved up to the extent the bullion has. We think most investors do not believe the move in gold is for real and that it soon will decline. If they are wrong, (and we think they are), the gold shares should have quite a bit of catching up to do when the market understands this bull market is "the real McCoy." In other words, if you share our bullish view on gold, now is a great time to buy some shares.



• Silver - In the high 4.80's silver is well above its 200-day moving average of $4.59. We continue to remain cautious on silver because we remain unconvinced it will play a major monetary role during a deflationary depression. We could be wrong about that because unlike copper and other bulk commodities, it does have the attributes to become more of a monetary metal. But our view is that when times get very difficult, industrial demand collapse could partly or completely cancel increased monetary demand for the metal. Therefore, if you want to play silver, we suggest you do it through some of our gold/silver plays such as Kimber Resources, Minefinders and Golden Goliath.



• Interest Rates - Gold is rising, Commodities are rising and interest rates continue to decline or at least remain low. That has many of the gold bugs shaking their heads and the reason they are shaking their heads is that they do not believe deflationary threats are real. Interest rates continue to defy the experts who think the Fed can and will reflate the economy. The bond rates, which have fallen this past week from already historically low levels as money is seeking a safe haven from stocks. But the move into bonds is indicating that the market is not in the least worried about inflation. That is not to say I believe interest rates will remain low. They will rise and perhaps dramatically so, when a massive exodus from the dollar from foreign investors begins to take shape. In other words, interest rates will not rise because of a desirable outcome of improving business conditions, but rather because foreign money flows out of the U.S.

Question: If I think deflation and not inflation is our number one concern, why are commodities still on the rise? What I think what we have seen so far is a growing recognition, at least by the so called professionals, that it is all over for the equity markets. And, in search for something that is real rather than the fantasies that the paper markets have been creating, investors have begun to allocate a small percentage of their resources into tangible assets, including home and bulk commodities. We think gold and perhaps silver will separate from the other items containing intrinsic value as it becomes clear that the economy is sinking into a deflationary depression. As demand falls for commodities in general, huge amounts of wealth will be shifted to monetary assets of true intrinsic value most notably gold and perhaps silver. Those items will become trusted mediums of exchange. Rarity and portability are characteristics that render gold the ideal place to park wealth when the financial system and economic activity collapses.

BEARISH MARKETS

• The dollar - The U.S. Greenback is in the opposite position of gold. At 100.23, the dollar index is well below its 20-day moving average of 101.82, its 50-day moving average of 103.47 and its 200-day moving average of 107.57. The buck's weakness is not necessarily evidence that foreign money has begun a net exodus from the U.S., but rather than the amount of inflow is decreasing. Given our enormous lack of saving, the reduction of even the amount of net inflow is beginning to lead to a weaker dollar. And no doubt U.S. participants are beginning to sell dollars and look for currency alternatives, which is most likely also leading to a weaker dollar.



• Equities - The Dow and the S&P 500 remain very weak. We believe we are still in relatively early stages of a very long secular bear market in stocks. Despite the huge declines from the March 2000 peak, they remain hugely overvalued in relation to earnings. Current over valuations combined with gloomy prospects for economic growth convinces us that stocks have much, much further to fall on the downside.

January 27, 2003

Jay Taylor, Editor of J Taylor's Gold & Technology Stocks
http://www.miningstocks.com