Furthermore, just as the recovery from 2003 to 2007 with hindsight now appears to be an illusion, it’s not impossible the multi-trillion dollar stimulus packages will yield something that feels like an economic recovery, also to be dismissed as an illusion a few years from now. GDP is supposed to be inflation adjusted, but nobody really believes the GDP deflator these days. Rising prices will give the government more cover for their fictitious measures and with rising numbers later this year or next I would not be at all surprised to see politicians and economists line up to claim credit. Once that happens everyone becomes vested in the recovery’s continued success. If the stimulus dollars stop flowing and the economy tanks once again, they will all look like fools, therefore the stimulus will likely continue until inflation tips and the government loses control.

Very few people in public office have the humility to admit their mistakes and reverse course, especially not on such a major defining issue. And once large businesses get a taste for government largess, I find it unlikely government officials will ever be able to withdraw the punch bowl without suffering a tremendous backlash. The least surprising result of all this inflation would be rising prices, but don’t confuse that for genuine economic growth.

The de-coupling theory has always been dependent on a dramatic appreciation of Asian currencies. I have always been a little skeptical of their intent to allow such an appreciation, which is the reason I generally avoided too much exposure to their equities, however my mood is beginning to shift on this issue. The herd that rushed into China 2 years ago has now been wiped out and my gut is telling me 2009 will be a pivotal year in world history. Some day people will ask, were you born before or after 2009? The status quo can not continue indefinitely, something must change.

It has been widely reported that China is pressuring the American government to “protect” their “investments”. Translated, that’s a warning not to inflate away their debts, but it’s becoming increasingly clear that quantitative easing (“printing money”) is around the corner, if not already here. It could be the only way to save politically connected banks and insurance companies from insolvency. Even Warren Buffet, the guy who famously declared he couldn’t care less about macro-economic issues is now warning of a possible “onslaught” of inflation.

If America debases the US dollar to wipe away excessive debts (much of which is owed to China) what will they do to retaliate? There is no guarantee China will shift to a more confrontational policy, but at least now there is a path to appreciation that didn’t previously exist. Whether any of these plans or retaliations will succeed is another matter, but the probability of de-coupling in the near future is now higher than at any time in recent history. Sentiment couldn’t be more bearish for emerging economies, that’s the sign of a bottom, not a top.

Failure of easy money

Enticing savers to borrow with low interest rates will not succeed; instead of encouraging more borrowing it will encourage savings in another form. Without interest there is no reason to hold cash in a savings account. With no borrowing and now decreasing capital the banks risk insolvency, and in such circumstances savers are better off withdrawing even more cash from the bank or buying gold and other more reliable assets with no counter-party risk. Easy monetary policy could cause bank failures by eliminating the incentive to maintain a bank balance, and thus encouraging bank runs. This is often called a liquidity trap.

It may appear deflationary at first as people stubbornly refuse to borrow, but ultimately fear of bank failures will cause the velocity of money to increase rapidly as cash is withdrawn. There is little difference between $10 spent and $5 spent twice in the same time frame, so deflation is really irrelevant to the debate. Such changes in psychology can occur much quicker than any central bank’s ability to react, causing the value of paper money to drop with frightening speed. Ask anybody who survived the Wiemar Republic, the process of moving from deflation to hyperinflation is stunningly quick.

Governments can insure everything in sight, but insure with what? Such promises are no better than credit default swaps issued by AIG. The government has nothing to back such claims other than a printing press and there is no higher authority to bail them out. With economic activity declining, so does tax revenue.

Failure of stimulus

Distributing dollars directly to a business with no customers will not create more customers, it will merely buy time, allowing fear to spread as employees are shifted to make-work projects and losses mount, increasing dependence on further government bailouts. There is no reason to produce a product that will not be consumed, if employment is to be maintained either the excess production will stop regardless of any bailout, or it will sit idle in warehouses forever. Either way, profitability will not improve and there can be no recovery. Everybody will have a job, but everybody will be broke as both income and productivity plummet. If employees are released from their positions, stability may return at some point, but in the interim consumption will decline even further causing general living standards to follow. Whether politicians can stomach such events despite massive bailouts remains to be seen. Distributing dollars directly to consumers will merely facilitate a flight away from dollars by giving people the means to diversify their savings, causing asset prices for gold and other instruments of savings to rise.

Hope?

I believe the only salvation lies with technology. Many of these problems would have likely occurred years ago if not for the “productivity miracle” resulting from personal computers, high-speed internet , mobile telecommunications, etc. We need a similar new paradigm shifting invention, probably in some other sector like energy or agriculture, to take us forward. However, unless such an invention is coupled with a more sustainable financial system we will likely return to this place again in the future.

That doesn’t mean I support government funded research, but it certainly would be the least offensive of all the bailouts I’ve witnessed so far. I would rather the entire $800 billion be spent on R&D than mortgages. However, we should appreciate the extent to which such policy is a gamble. If it succeeds everybody looks like a genius. If it fails, the end result could be equally catastrophic. Capitalism generally doesn’t work when people risk other people’s money.

There are two ways a currency can lose value, inflation or hyper-inflation. People often consider hyper-inflation a “really bad” inflation, but it’s not, it’s a fundamentally different concept. Inflation is a deliberate act of policy, hyper-inflation is a black swan event. Inflation is monetary, hyper-inflation is psychological. Inflation is manageable, hyper-inflation is chaotic.

It’s now fairly obvious to everyone that despite an expanding money supply the collapse of credit has caused a deflation-like environment. Prices are crashing everywhere. The economy in general is still way too levered so it’s difficult for me to believe this trend will reverse dramatically in the foreseeable future; despite almost free money everywhere banks are justifiably cautious and credit-worthy borrowers aren’t too excited about the prospect of new debt given economic and market conditions… All deflationary, all true… but none of it really matters.

For the same reason short term treasuries had negative yields, as quickly as people stopped consuming, they can stop saving in dollars. Culture can change in a matter of weeks and investors have demonstrated a willingness to PAY for safety, it’s only reasonable to assume the same holds true for ordinary people. Even in a deflationary environment with the value of dollars going up, people will exchange those dollars for something perceived to be more safe despite the cost of missed potential appreciation and minimal interest. Commodity price trends and the availability of credit is not relevant to the hyper-inflationary debate, the only question is one of confidence. After 2008, nobody can argue people are unable or unwilling to modify their habits very quickly when psychology changes. The Wiemar Republic had a period of deflation immediately prior to their hyper-inflation, this is no time for complacency.

If the economy recovers

People often claim Americans will never lose confidence in the dollar because all their income and expenses are in dollars. I don’t care what Americans think, too many US dollars are held by foreigners. Americans are no longer masters of their domain. The US dollar is the global reserve currency, the first global reserve currency not backed by a commodity.

To understand why foreigners may become willing to divest their dollars you must understand the critical distinction between the economic problems in America and Asia. Everyone is suffering from a lack of demand, but stimulating demand is much easier in Asia where many people have no possessions and lots of savings. How will Americans spend more when they’re already saturated with cars, televisions, electronics and still levered up to their eyeballs? The old game of Americans consuming and Asian producing is dead forever. The world doesn’t need America to consume on its behalf, re-modeling your kitchen does not create prosperity in Asia. If you expect the economy to eventually recover with a return of demand, it will come from abroad. So we must ask this important question: What will they buy?

Other than Hollywood, bombs and claims of freedom, Americans have little to offer the world. It’s tough to see an economic recovery helping the US dollar without dramatic structural changes to the US economy, a significant increase in immigration, or a significant decline in living standards – none of which are out of the question. Should a recovery emerge as a result of some incredible technological breakthrough developed in the US and exported abroad, all bets are off. But how likely are these things, really?

Normally this would simply require a re-balancing of global currencies, not the least bit hyper-inflationary, but in this case large reserves are held by a small number of people. A decision to dump by any one of them could precipitate a panic. There is no way to predict whether the dollar will suffer a steady decline or hyper-inflationary collapse, but I’m not taking any chances. A falling dollar is a falling dollar, gradual or not.

If deflation or zero growth persists

Without growth people will focus on safety. In 2008 this trend was a net-benefit for the dollar, but with eye-popping budget deficits around the corner that may not last for long. America has a questionable ability to repay its existing debts, let alone new debts inspired by double-or-nothing stimulus packages. Should they fail, not only will it mean more interest payments but combined with a persistently weak economy it further threatens the ability of government to raise revenue through taxation.

If the economy is going to suffer anyway, surely it would be preferable to do so with less debt. Deflation kills debtors because it increases the amount of work required to earn the same number of dollars, plus interest. In other words, when a system is as debt dependent as the US, deflation is the opposite of safety. If you’re looking for safety in a deflationary environment, look elsewhere.

Other than central bank reserves and speculation there is only one reason to hold the currency of another nation – to buy something produced in that country. If there is no safety and no technological breakthrough, for what purpose will foreigners hold US dollars at these ridiculous yields? No safety, no goods, no yield… no deal.

The most significant unknown is how quickly people will react. Investors will liquidate their dollars first in anticipation of future declines, but this crisis will likely never reach hyper-inflation without foreign central banks playing ball. I am confident ordinary people will understand the impact of an insolvent US government, or at least its repercussions like an emerging gold bubble in the physical market, but I don’t know how quickly public pressure can force central bankers to act. Perhaps they never will, but I’m not taking any chances.

The catch

As bad as American prospects appear, it’s even worse in many places abroad. In other words, assuming my belief the dollar is doomed translates into stronger foreign currencies is misplaced.

Obviously some will increase in value, particularly in Asia, but many will be debased in tandem with similar monetary and fiscal policies abroad. Debt is not exclusively an American problem. The US dollar may be as safe relative to some European currencies as US equities were relative to some European equities. They will all go down together, but some more than others. In that case, it’s best to avoid them all. There is no reason to expect an emerging dollar crisis to be contained within US shores.

Conclusion

Of course you know where I’m going with this, all roads lead to gold.

Governments can only raise money in three ways: taxation, borrowing and printing. When the purpose of your deficit is stimulus, it wouldn’t make any sense to raise funds through taxation. In fact, Barack Obama has already stated his intention to reduce taxes for 95% of the public and freeze the current level of taxation for the rest. Similarly, when you’re trying to kick-start the economy it would be counter-productive to sell bonds to the public, that removes money from circulation. They could sell bonds to foreigners, but that assumes demand will remain for these securities in the face of economic softness abroad. Foreigners are more likely to sell their existing treasuries to stimulate their domestic economies rather than buy more. The only remaining option is to print.

The mechanism by which this will be accomplished has already been announced by Ben Bernanke. The Federal government will issue new treasury bonds, but instead of being sold to the public they will be sold to the Federal Reserve. Of course the Federal Reserve has no money, they will buy it with a wink and a nod by just typing some number in a government bank account. They no longer even need the paper…

The way I see it, this could play out in one of three ways:

• The value of treasuries will remain high (due to artificial demand created by the Federal Reserve) while the US dollar implodes as everyone looks for safety elsewhere (rates will be too low for both debt and savings).
• The US dollar gains strength temporarily as everyone dumps treasuries in favor of cash. This would be a transient move as people panic-sell their bonds and park capital in US dollars creating technical demand for dollars until they find something better. The process of finding something better could span minutes to months. This would be a similar unwinding to the carry-trade reversal we witnessed with stocks. Long term bond yields shoot to the moon.
• The worst case scenario, both the US dollar implosion and long term yield increases happen at the same time… This is the better-have-physical-gold scenario. If the Federal Reserve becomes the only buyer of treasuries and the US dollar begins to decline, it could drop like a giant snow boulder tumbling down a hill picking up more speed and mass the farther it moves. The longer it’s permitted to continue the more snow it absorbs and the more difficult it becomes to stop.

I wonder if perhaps a combination of all three is in our future. The most obvious question-mark is whether people will actually dump their treasuries in the face of tiny yields. We have seen short term bills rise dramatically despite negative yields, could that not be repeated with the long bond? My personal opinion is no, and the reason is simple – there is so much uncertainty about the next 30 years with respect to demographics, social security, medicare, the rise of China and the availability of resources, etc. that nobody has any measure of confidence a dollar returned 30 years from now with have enough value to justify the opportunity cost. Who locks in their cash for 30 years with a declining empire brimming with debt and facing hyper-inflationary monetary policy? The fundamentals that drive demand for bills are different than bonds. If the purpose of buying government debt is a rush towards safety, bonds don’t make the cut.

Of course for that to be true, there must an alternative investment with at least equivalent safety and the prospect of better returns. I have suggested in other posts that gold could serve this purpose. Gold can rise in both deflationary and inflationary environments, but especially hyper-inflationary. Gold suffers only during periods of low-volatility and low-uncertainty, that’s the opposite of the next few decades.

The market for discretionary goods is very large and volatile. There are certainly many things people can do without, but spending will never go to nothing. The performance of the market is irrelevant to our need for food and shelter. People may frequent restaurants less often and moderate their living conditions, but they will eat something, wear something and live somewhere. Homes will be heated, electricity will flow, cell phones will transmit and some form of transportation will still be required. As unemployment grows people will flock to reasonably priced entertainment. Prices may adjust as usage is moderated but these things will never go away.

How we got here

Prior to the 20th century we used to make decisions to buy based on function, quality and value. A new era of stupidity began when marketers and public relations experts learned to promote products based on personality types using psychological techniques – people no longer bought clothes, vehicles or whatever for certain features or a reputation of quality, they purchased these items to make a statement about how they wished to be perceived by the world. This behavior has always been common at the highest levels of society but now there was a premium on image even for the masses.

This experiment may not end completely, but there appears to be a growing unraveling of such consumerism. The key point, however, is that these ideas are firmly rooted in our heads and nobody will stop wanting – people are being forced by events to cut back – thus many will harbor extreme bitterness at the prospect of a life filled with unrealized dreams. If you never knew a dishwasher you would never miss it. Most people would have never achieved their goals regardless, but the critical distinction here is the lack of hope and loss of confidence in the future. When a critical number of ordinary people fail, the culture changes.

How people will react

The middle class has been irresponsible, but they will not accept any blame because everyone was led down this path by an arrogant elite who are now busy bailing themselves out. People always look first and foremost to blame an outsider for their problems and these bailouts are making it too easy. Ordinary people will complain to their friends and family who will regurgitate the same views and everyone’s beliefs will be re-enforced. Once an idea takes hold, cognitive dissonance ensures many will try to rationalize away their dissenters in the face of any contrary evidence. Meaning, there is a point of no return.

When we pass that point, it will no longer be politically correct to flash piles of cash and diamonds in music videos or at awards ceremonies. Pulling up in a fancy car or flying around in a private jet will become uncouth. Sacrificing for the future will be the new statement – stick it to the man by refusing to play their “consumer” game.

The economic impact

People will make full use of their existing property until the date of expiration. As a result, the replacement cycle will be extended for many products – but not to infinity – eventually everything fails. For example, many people have been purchasing faster and flashier computers at fairly regular intervals for years. Today, there aren’t many consumers interested in computers who are not already equipped with machines sufficiently powerful to meet their demands. Personal computers won’t go away, but production will be scaled down. The same is true for many other industries. Companies will scale back on IT spending leaving hoards of programmers with nothing to do, since an increased number of unemployed people will be using their computers all day there could be interesting opportunities on the internet, but only for self-funded startups with actual revenue models that profit from changing trends. Many service sector jobs will be decimated. People will cut their own hair, maintain their own lawns (or just ignore them) and avoid accountants and lawyers wherever possible. Look for ineffective home remedies to make a comeback. I would expect insurance fraud to become a huge problem.

The fallout

The end result of these changes is difficult to predict. Many of the benefits of increased production have been absorbed by a tiny minority at the top of society, therefore it’s not unreasonable to believe they will suffer the most from an economic contraction. However, since this small community of CEO’s and financiers are pulling all the strings, it’s also not unlikely they will find a way to socialize their losses to the entire population. We’ve already seen that trend in the financial and auto sectors.

Certainly as local governments refuse to reduce property taxes despite falling real estate valuations, state governments begin raising taxes to avoid huge deficits as they are unable to raise money from the private sector, tax rebellions and civil unrest are not out of the question. It’s difficult to gauge the response from government in that case, I can’t imagine they will have the funds to feed millions of protesters in prison for any duration sufficient to deter future violators. We could very likely see the Federal Reserve buy local government debt to finance daily operations.

But none of that money will circulate and every dollar a person hoards is a dollar not being earned by a producer. Combined with a lack of credit we will see major contractions of supply. As people lose jobs, people spend less. As people spend less, more people lose jobs. Combined with the unprecedented actions of the Federal Reserve we will see a significant increase in the ratio of dollars to goods – the exact definition of inflation. But here is the catch, the dollars will not be spent. If the dollars don’t circulate, price inflation can’t happen. Which means we could have massive monetary inflation and paralyzing deflation at the exact same time, a perfect recipe for hyperinflation.

The interim will feel like deflation, but that will only last until the day it doesn’t. We aren’t likely to see a re-emergence of bubble inflation any time soon but when the mass printing of dollars by the Federal Reserve causes people to doubt the usefulness of paper currency to store their purchasing power, look out. The poor may be hungry, but the rich will find the whole world scrambling to allocate their freshly created paper bills to assets perceived as safe. Right now, that’s treasuries, but eventually that bubble will burst and all that cash will look for another home. With manufacturers bankrupt and commodity producers unable to finance exploration due to falling prices, the supply of goods will be extremely tight at precisely the moment the supply of dollars will be at its height. Picture a giant tower of cash leaning over a few pieces of cheese being fought over by mice. We could go straight from a deflation-like environment to hyper-inflation with very little notice. And if that occurs, don’t pretend for a moment raising interest rates or selling bonds at higher yields will stop it. Hyperinflation is as much psychological as monetary.

Nobody knows how long it will take for people to lose confidence in paper currency, or what event will do the trick, but the unholy alliance of Keynes’ ghost, money-printer Bernanke and big-spender Obama may make it inevitable.

Last year most people were totally clueless. Today, they find my actions more curious than weird. With interest rates at an all time low, currency valuations in doubt, stocks markets plunging all over the world, real estate markets crashing, and many warning of a pending bubble in government bonds, there is nowhere to hide but precious metals. It’s unlikely more banks will fail, but individual corporations may start to drop like dominoes, possibly even institutions managing the popular exchange traded funds. Gold has zero counter-party risk, it pays no dividend but it can’t go bankrupt. The value may fluctuate but it will never go to nothing. Gold has outlived every stock, every bond, every country, every currency.

The more sophisticated banker types aren’t surprised to hear my argument, even though nobody has done anything about it, I get the distinct impression they’ve heard it all before and buying some physical metal has crossed their mind. Regular people understand the rationale but still regard gold for savings as a foreign idea, but a few ask to see some bullion. Overall, I am convinced the gold market has barely been tapped by ordinary folks. We are so far from a top it would be funny if it weren’t so scary.

I believe the primary obstacle to a further adoption of gold for savings among the general public is a cultural barrier, people have been trained to believe gold is old fashioned or a scam run by bankers. The real scam is dollars, they’re just worthless paper. At least silver has many industrial uses and gold is pretty! I always tell people to buy a few coins or small gold bars, nothing too elaborate, because I am convinced once they have it in their possession and see it in their hands it will become clear. Humans are attracted to gold like bugs are attracted to neon lights. There is a reason gold has survived as money for thousands of years — it works.