About this time, when some aspect of the economy is in trouble, the deflationists come out of the wood work with the equivalent of sticker shock “catch phrases” and “hunker in the bunker” ideologies. This will cause those who are just getting interested in commodities to develop a case of the jitters and bail. In Science, failure to look for the root cause of a problem rather than symptoms leads to an improper diagnosis and this just as true in the financial markets. I am writing this for those considering investments in the commodity arena performing the required due diligence.

The amount of money floating around is the key to inflation, whether it is derived from printing or issuance of credit. An increase in money supply drives inflation i.e. more money chasing the same number of goods. With all of the money churning around the globe, it must have a certain velocity to keep the economies of the globe flowing smoothly. A substantial decrease in velocity of money results in lower economic activity, which results in fewer jobs, less demand for commodities, etc. i.e. recession.

US Economy

Increasing house prices through irresponsible credit availability will require more money printing to compensate for stalling velocity in time. Inflation normally has rising interest rates to compensate investment interests (banks must charge more than inflation rates in order to make money). Since the US housing market is where most individuals concentrate net worth, the FED must keep rates as low as possible until many of the newer adjustable mortgages get reset over the next year. Artificially low interest rates create a negative real return, which bolsters the price of precious metals.

Manufacturing is the basis for economic trade, where in better times goods are traded for money, which is acquired by selling the fruits of your trade. Here, there is a sustainable trade-off. Conversion to a service-based economy can only last for as long as there is money flowing. When the USD eventually falls, this will be the result of foreigners no longer wishing to trade in US wares at current prices. Although 50 million Americans are likely to lose their homes and suffer through the coming economic crisis, there are still many wealthy Americans who will continue to purchase goods. But most importantly, it's key to understand foreigners will drive increasing commodity demand at the margin.

So, if wedding planners and homebuilders are going to be out of work in the US, where will the coming bull market exist? The bull market in the US economy during the next 3-5 years will be predicated on the preservation of wealth in my opinion. Baby boomers are going to require an income stream due to a declining USD and inflationary pressures so they will seek refuge from the current options. Total gold stocks and silver stocks are worth no more than $150 billion, total available gold at $600/ounce and 145,000 tonnes ever mined is approximately worth $3.07 trillion dollars. Available above ground silver at 800 million ounces (22.3 thousand tonnes) and $12/ounce is worth approximately $9 billion dollars. Note that silver is primarily considered an industrial metal and that 800 million ounces can disappear quite fast, which is equal to the approximate amount mined globally per year.

Grandfather statistics charts shows that increases in government spending have benefited the masses. What's more, the trend toward pandering the masses will likely continue. This means savers will be penalized, having to pay higher taxes. The wealthy will not like this, which will be a driver of gold to hide net worth. American debt is approximately 44 trillion, which is mind boggling how many zeros are in that figure. The only solution possibly feasible to pay that much debt off is to print more money. All debt will be paid, but debt holders will lose purchasing power. 

One sign big businesses know a credit crunch is not too far off is many seminars are advertised in newspapers offering 30-40% returns YOY to individual investors. These are debt portfolios of companies that are trying to unload them on to the moms and pops. Nobody sells the goose that lays the golden egg unless it is cooked, so in my mind a credit crunch is looming.

 In Japan, the government fought tooth and nail to prevent deflation due to their populous being notorious savers. People refused to spend money and further accumulated it, so the amount of available money in circulation fell sharply, which is one aspect of deflation i.e. If all of the richest people in the US were to convert all their assets into cash (since they control 85-90% of the economy), deflation would occur. The masses of Canada, USA Britain and Australia are not savers so the chances of a Japanese type of event being repeated is non-existent. And would you believe, the Chinese and Indian cultures are starting to adopt the credit lifestyle.

Global

The US was the world’s power when it was the world’s largest exporter of oil and manufacturing center. Since the end of WWII, the US global output has declined from 50% to an estimated 20-22%.  Dollars flow to sources of manufacturing, which now is the domain of China and India. The US economy has been rolling along with the aid of other countries purchasing US debt instruments to fund the current account deficit. Removal of this additional money and the US faces a sudden negative influx of capital. When this situation arises the US government has 2 choices: 

Deflation, which would absolutely collapse the entire US economy to a functional level of less than 20% of the population. 

Monetary inflation to cover the bills so that the economy hobbles along.

The important item to remember is that ALL global economies are linked and any country that expands its own currency will automatically cause monetary expansion of any country it does trade with. China has nearly 1 trillion US dollars in its reserve, but what if they lost 1 trillion with internal loans to cancel their reserves? They simply print a trillion of their own currency and buy more US debt. This perpetuates the cycle in which we exist, so until the consumer goes into the bunker, this facade will continue. 

Once the consumer retreats and the bad loans begin to hit the banks, governments will have to bail out a multitude of companies to keep the economy running. Remember that if the debt is mopped up with mad money, then it matches and raises any money that evaporated, hence inflation.  On this basis, it is nearly impossible to consider any form of deflation until the inflationary cycle is over.

War cycles are always inflationary and countries tend to go off of gold standards to ensure supplies and oil are not limiting to try and ensure victory. This has been the case for many currencies of the past 200 years and will continue into the future. Interestingly, Portugal, England, Spain and France during the 1500's to the 1700's were able to grow their economies by stealing gold from the South American countries during their global conquest phases. Their gold was basically free, which was able to feed their fleets and government purchases etc. With the abolishment of slavery and loss of control of the "New World" from feuds with other European countries and the locals, this form of a gold-backed currency system for funding wars and growth no longer exists.  Stealing from other countries for nothing was a form of printing money except it came from the ground and went to European banks with no purchase of cash required. Today, instead of robbing countries of gold and silver, banks print money to allow credit expansion for citizens to go into debt to have a household containing the latest gadgets. Money today is basically digital, a total 360 going from physical to money transferred electronically.

Any attempt to implement a purely digital economy never could and never will exist. People would return to bartering and ignore the electronic money system, which would negatively affect government revenues. This would collapse economies, so I would hazard a guess this system would never fully be implemented. Most transactions nowadays are electronic but there always is the basic need to transfer money between individuals. Another reason to own gold and silver: the government can not trace it.

Baby boomers in North America will be retiring en masse in 2008, but most are not financially prepared. Pension funds are under funded and will be betting the farm on rising precious metal stocks and energy stocks to beat inflation. If boomers have big chunks of money, they will naturally sit on it like an egg, which would result in less cash circulating in the economy. Most baby boomers have little to no money and are not financially prepared for retirement so any repeat of a similar event the Japanese had between 1989-2004 is highly improbable as discussed earlier. People will be trying to secure their future nest egg on borrowed money by participating in the commodity boom. Where does all of this wind up? This is where technical analysis and use of Elliot Wave (based upon Glenn Neely’s principles) come to play. For a prior article describing the methodologies of technical analysis I use, refer to The Technical Palette.

As I stated earlier, the amount of money circulating in the globe is expanding and just because the US is going through hard times does not remove inflation from the global scene. The scenario of an inflationary depression is what I would expect and is worse than a deflationary depression. During an inflationary depression the price of food and goods rises above many households’ range of affordability.

In the end, there will be a deflationary collapse following the current period of inflation and it will be due to a zero velocity of money compounded with plummeting manufacturing output. At this point in the future, owning cash and bullion will be important.

© 2006 David Petch
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